Federal Reserve shouldn't lower interest rates much more

Next week, Federal Reserve policymakers are expected to reduce interest rates by a quarter-point.

The bigger issue is how much further the Fed will take rates, which confronts the Fed with five questions:

1. How is the job market?

President-elect Donald Trump is inheriting an economy growing 2.8% annually, well above the 1.8% trend presumed possible by the Congressional Budget Office, and unemployment remains reasonably low.

Although the October and November jobs numbers were somewhat distorted by hurricanes Helene and Milton and the Boeing strike, for the year ending in September, the economy added 195,000 jobs a month — well above the 80,000 population growth and regular immigration would permit.

Illegal immigrants are finding work, and we need 1 million to 1.5 million more legal immigrants to maintain the current pace of economic growth.

Employee compensation is rising 3.9% annually, which is consistent with inflation at about 2% and productivity growth trending at 1.9%.

Job searches for the unemployed are getting longer and tougher, but lowering interest rates too much could accelerate the increase in labor costs due to skill shortages.

2. Have we reached price stability?

The consumer price index is rising at a 2.6% pace; when food and energy prices are excluded, it’s 3.3%. The headline figure of 2.5% may have to be good enough.

Goods prices have been falling because oil prices have dropped. China’s property sector and broader economy are in a funk, and Beijing is propping up employment by encouraging overinvestment in manufacturing and pushing subsidized exports.

We get cheaper electronics at Best Buy, thanks to joblessness in China.

In contrast, services prices, including the cost of shelter, continue to rise at about 4.8% a year.

We can’t rely forever on the gluts of oil and housing in China, and the Fed should further reduce rates cautiously.

3. How much bang is the Fed getting for Its interest rate cuts?

The federal funds rate is what banks charge one another for overnight loans, and in turn, that’s expected to ripple up the yield curve to influence the 10-year Treasury rate and other rates that benchmark off it.

Since the Fed first cut the federal funds rate in mid-September, the 10-year Treasury rate has risen, not fallen as expected. Similarly, mortgage rates and corporate bond rates across risk profiles have trended up, though credit card rates have fallen a bit.

It appears that investors don’t share the Fed’s confidence that inflation is converging on 2%, or they expect stronger U.S. growth than the historical norm to continue — thanks to big federal deficits and a productivity boost from artificial intelligence.

If the Fed lowers interest rates too much, it will exacerbate bond market skepticism about inflation and overheat the AI-inspired investment boom.

4. What will be the inflationary impact of Trump’s policies?

Economics students are taught that macroeconomic policy is like a scissor: One blade is monetary policy, and the other is fiscal policy, best summarized by the government deficit.

With President-elect Donald Trump, it becomes a multiple-blade thresher by adding harassing the Fed, tariffs, dismantling President Biden’s industrial policies that are boosting supply-creating investments in semiconductors, green industries and electric vehicles, and deporting employed immigrants.

With the exception of imposing a 60% tariff on Chinese goods, the new administration can expect progressive opponents to bring many lawsuits.

Mr. Trump can tighten border policy and expel criminals and those with outstanding deportation orders. Beyond that, it gets messy, and he would face litigation.

Given the millions of immigrants in the country illegally, a limited policy should not be inflationary. But if his policy gets too draconian, it will constrain labor supplies and stoke inflation.

The great lesson of the recent election is that pursuing policies that boost inflation is a hanging offense. Mr. Trump will be a lame duck once he returns to office, but not his GOP allies in Congress.

Expect Mr. Trump to dial back expectations for change.

5. What’s the inflation-adjusted rate of interest (R*) that neither stokes demand and inflation too much nor slows productive investment and growth?

In its latest projections, the Fed’s target for the long-term federal funds rate is 2.9%. With a 2% target inflation rate, its policymakers assess R* to be 0.9%.

With the U.S. economy's growth prospects much higher than before the pandemic, R* is closer to 1.5% to 2%.

With inflation in the range of 2.5%, the logical target for the federal funds rate would be 4% to 4.5%. The upper bound is not very different from where it should be next week.

Mr. Trump is a real estate developer and, by anatomy, has a passion for lower interest rates. Failure to couple effective border enforcement with meaningful immigration law reforms will stoke inflation and require much higher interest rates than 4.5%.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.