#todayinsight: Steady Amidst the Storm: The Fed Holds Rates Steady as Inflation Challenges Persist!

The Federal reserve decided to hold the rates constant in the March meeting. The inflation target is 0 to 2 percent annually and the CPI is now pointing at 3.4 percent  on a yearly basis. Thus, the inflation is still above desired levels. Fighting inflation for the FED has been easy and challenging simultaneously. Easy, in the sense that the rate has not been pushed up in the last eight months. And challenging in the way that, the FED does not see the desired cool down of the inflation.

In its outlook, the FED still estimates three rate cuts in 2024, but it decreased its projection for rate cuts in 2025 from four to three. Still some prominent measures of inflation are stuck at 3 to 4 percent annually. Core CPI which strips out volatile food and energy items raised 0.4 percent monthly in both January and February 2024. It is too much, in fact this trend is continuing for 12 months, the annual core inflation would be close to 5 percent, that is much more than the FED 2 percent, maximum desirable inflation of 2 percent. Still, future market contracts show that the financial market is betting for a rate cut in June.

From an economic point of view, FED  is increasing its estimate for the natural interest rate. Since 2019, its estimate of natural interest rate was 0.5 percent (nominal interest rate of 2.5 percent, minus 2 percent inflation which adds up to 0.5 percent). Natural interest rate is the equilibrium rate of capital lending/borrowing, at this rate, the monetary policy is neither expansionary nor  contractionary. It is not possible to observe this rate, but in the long run the average interest rate should be close to this rate, and the FED always tries to have a precise estimation of this rate.  

However, the recent projections shows that the FED estimation of natural interest rate is rising. It is currently 0.6 percent. This lies at the core thinking of the central bank that in recent years a higher interest rate is needed to prevent the economy from overheating. Perhaps AI contributing to productivity and growth  or government overspending are the causes of the recent rise in the natural interest rate.

Source: Economist