[Insight & Opinion] The Fed Has Often Been Wrong

The U.S. Federal Reserve (Fed) began raising interest rates in March of last year. In just 1 year and 4 months, it has increased rates by 5.25 percentage points. Historically, the Fed has lowered rates as quickly as it raised them. Wall Street expects that rate cuts could begin as early as March next year, with a total reduction of 1.25 percentage points by the end of the year. According to the Fed's dot plot, the expected benchmark interest rate at the end of 2024 is 4.6%. Assuming a typical rate cut of 0.25%, it is possible to anticipate three rate cuts. This is the current situation.

When forecasting the future, it is important to keep in mind that there is an underlying assumption. The current outlook for rate cuts is based on the judgment that inflation has been somewhat controlled. However, judgments can always be wrong. In 2021, the Fed underestimated the inflation trend as a temporary phenomenon and raised rates abruptly later on. There is no guarantee that a similar situation will not happen again.

The recent slowdown in inflation is largely due to the decline in international oil prices. Increased production and decreased demand combined to cause oil prices to drop by about 30% since last September. However, the trend of international commodity prices is difficult to predict, and geopolitical variables are unpredictable. There will also be many elections next year, which increase the likelihood of changes in fiscal policy. Inflation could rise again just from signals that rate hikes will stop. If expectations of easing outweigh the effects of tightening, the Fed’s choices will change. More evidence is needed to be confident that inflation is approaching the target level of 2%. It may take until after the first quarter. Even when rate cuts begin, adjustments will likely be repeated while monitoring the situation. For the U.S., there is no reason to rush as long as the economy is doing well.

Even if rates fall, it will not be easy to return to previous levels. The fact that the U.S. economy remains strong despite high interest rates means that the U.S. potential growth rate has increased accordingly. The neutral rate of interest has likely risen as well. The neutral rate refers to the theoretical interest rate level at which the economy can maintain its potential growth rate without inflation or deflation. Current estimates place the U.S. real neutral rate between 1.5% and 2%, meaning that to achieve the target inflation rate of 2%, the benchmark rate must be maintained above 3.5%. Applying the Taylor Rule for appropriate rates yields a similar level. It is better not to expect a rapid return to ultra-low interest rates.

The Bank of Korea has found it difficult to either raise or lower its benchmark rate so far. Korea’s benchmark rate is 3.50%, about 2 percentage points lower than that of the U.S. However, the end of the U.S. rate hike cycle only reduces one pressure factor for rate increases. In November, the U.S. consumer price inflation was 3.1%, but Korea’s was higher at 3.3%. At last month’s Monetary Policy Committee meeting, four out of six members were open to the possibility of raising the rate to 3.75%. The Bank of Korea’s rate cuts will likely follow confirmation of U.S. rate cuts. If the U.S. lowers rates around May or June after the first quarter of next year, it seems realistic that Korea could cut rates around July. Expectations that are too premature could lead to greater disappointment. It is better to watch a little longer. Economic forecasts are often wrong. To reiterate, the Fed’s judgments and predictions have frequently been incorrect.

Kim Sang-cheol, Economic Commentator

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