The Fed just cut interest rates again – and the timing is undeniably bad

Fed officials emphasize that their decisions depend on economic data, concrete signs about the economy's health and possible direction. But there is one key concept that guides the Fed, which Chair Jerome Powell says is “theoretical” and “not directly observable.”

This is the so-called “neutral interest rate”, an interest rate level that neither stimulates nor dampens the economy. The Fed's most important tool is its key interest rate, which influences the cost of borrowing throughout the economy. Its function is to either stimulate demand when interest rates are low or to cool demand when interest rates are elevated. That depends on whether the Fed is dealing with high inflation, which causes the Fed to slow the economy, or high unemployment, which forces the Fed to do the opposite.

Economists call the neutral interest rate theoretical because it depends on many, many factors that make it too imprecise – such as population growth, productivity, saving patterns, any structural changes in the economy, etc., in addition to the impact of borrowing costs.

With inflation having fallen significantly since its four-decade peak in 2022 and now just a touch away from the Fed's 2 percent target, the Fed has been paying more attention to America's job market, which has been growing steadily in recent years has become weaker. Things remain good, but Powell telegraphed in September that the Fed was determined to maintain its strength and avoid deterioration.

Fed officials have said they believe borrowing costs are still at restrictively high levels, endangering the labor market. Now it depends on how quickly the Fed wants to bring interest rates back to neutral. Of course, that also depends on inflation. Some officials said they don't feel the need to cut interest rates.

“I’m in no hurry to go neutral,” Atlanta Fed President Raphael Bostic said at an event in Jackson, Mississippi, last month. “We need to get inflation back to our 2% target and I don't want us to get to a point where inflation stalls because we haven't been restrictive for long enough. So I will be patient.”