Has The Federal Reserve Waited Too Long to Cut Interest Rates?

The Federal Reserve is widely expected to cut its benchmark interest rate for the first time in four years at its policy meeting next week, after holding the rate at a two-decade high for the past year.

High borrowing costs have weighed on the U.S. economy as the Fed hiked rates starting in 2022 to battle inflation. But now that the central bank is all-but-certain to announce a rate cut next Wednesday, some economists are asking: What took so long?

“Typically, the Fed always waits too long, and it’s likely that will be the case with this Fed,” wrote Dan North, senior economist at Allianz Trade Americas.

Fed Concerned About Labor Market Weakness

The Fed has held the fed funds rate at a range of 5.25% – 5.5% in the hopes that high borrowing costs would discourage consumer and business spending, therefore easing price pressures. 

The Fed’s preferred measure of inflation, which hit a post-pandemic high of more than 7%, has fallen to 2.5%, nearing the central bank’s annual target rate of 2%. At the same time, the surging labor market that helped spur inflation has begun to cool under the weight of the high interest rates.

Fed Chair Jerome Powell and other officials have acknowledged the progress on inflation while expressing concern about the weakness in the labor market. They’ve also said that inflation doesn’t have to fall all the way to the target level before interest rates are cut.

In the eyes of some economists, the signs have been clear that an easing of interest rates should have already happened.

“I think the Fed should have started to cut rates earlier since the labor market and overall economy are softening meaningfully and inflation, despite some bumps along the way, is trending lower,” said Kathy Bostjancic, senior vice president and chief economist at Nationwide

Bill Adams, chief economist for Comerica Bank, said that strong jobs market data helped motivate the Fed to keep interest rates elevated. But with the downward revisions in some of that data, the labor market is weaker than it appeared.

“After badly missing the inflation target between 2021 and 2023, the Fed erred on the side of waiting longer to cut rates this year, even if it risked a weakening job market,” Adams wrote. 

Will Fed Play Catch-Up?

Some economists argued that the Fed needed to cut interest rates at its July meeting, where rate cuts were discussed but ultimately officials voted to keep borrowing costs unchanged.

According to some estimates, current interest rates could be as much as two percentage points too high for current economic conditions, meaning that Fed officials may need to play catch-up. 

“They might even think, whoa, we’re behind the curve,” said Robert Kavcic, senior economist at BMO Economics. 

The Fed has typically been slow on changing interest rates because officials either have misjudged the time lag to see the effects of rate changes, or they are waiting as long as possible to make sure that inflation doesn’t reaccelerate, Allianz’s North said.

“Unfortunately, by waiting too long, the Fed has historically slowed the economy sharply,” he said. 

One signal that could show that officials believe they were too slow on cutting interest rates would be if the Fed cut rates more than the standard quarter-percent point that most economists see coming. 

“It would also send the wrong message to the financial markets, that is, one of panic on the Fed’s part,” said North.

As of late Thursday, market participants were pricing in about a 33% chance that the Fed will cut the benchmark rate by half a percentage point next week, according to the CME Group’s FedWatch tool, which forecasts rate movements based on fed funds futures trading data. That’s up from around 15% Wednesday but well below the 50% probability that was priced in last Friday following a weaker-than-expected jobs report for August.