Why cut interest rates in such a strong economy? A big question for the Fed.

The Federal Reserve is widely expected to leave interest rates unchanged following its meeting on Wednesday, but investors will closely watch for any indication of when and how much rates will be cut this year. year.

The expected rate cuts raise a big question: Why would central banks cut borrowing costs when the economy is growing surprisingly strong?

The U.S. economy grew 3.1% last year, up from less than 1% in 2022 and faster than the average for the five years before the pandemic. Consumer spending grew faster than expected in December. And even though hiring has slowed, America still has an unemployment rate of just 3.7%, a historically low level.

Data suggests that although the Fed raised interest rates to a range of 5.25 to 5.5 percent, the highest level in more than two decades, the increase was not enough to curb the economy. In fact, growth remains faster than the pace many forecasters consider sustainable in the long term.

Fed officials themselves forecast in December that they would make three rate cuts this year as inflation gradually slows. Yet falling interest rates in such a robust environment might require some explanation. Generally, the Fed tries to keep the economy balanced: lowering rates to fuel borrowing and spending and speed things up when growth is weak, and raising them to slow growth and ensure that demand does not overheat and does not push inflation upwards. .

Economic resilience has led Wall Street investors to suspect that central bankers may wait longer before cutting rates – they previously bet heavily on a cut in March, but now see the odds as just 50-50 . But some economists say the Fed may have good reason to reduce borrowing costs, even as the economy continues to grow.

Here are some tools to understand how the Fed plans its next steps.

The central bank will not release new economic projections at Wednesday’s meeting, but Jerome H. Powell, the Fed chairman, could provide details of the Fed’s thinking at his news conference after the policy decision. 14 hours.

One of the topics he will likely touch on is the all-important concept of “real” rates – interest rates after subtracting inflation.

Let’s unpack this. The Fed’s main interest rate is stated in what economists call “nominal” terms. This means that when we say interest rates are set around 5.3% today, that number doesn’t take into account how quickly prices are rising.

But many experts believe that what really matters for the economy is the level of interest rates after adjusting for inflation. After all, investors and lenders take into account the future purchasing power of the interest they will earn when making a decision to help a business grow or provide a loan.

As price pressures ease, economically relevant real rates rise.

For example, if inflation is 4 percent and rates are set at 5.4 percent, real rates are 1.4 percent. But if inflation falls to 2 percent and rates are set at 5.4 percent, real rates will be 3.4 percent.

This could be key to Fed policy in 2024. Inflation has been slowing for months. This means that although interest rates today are at exactly the same level as they were in July, they have risen in inflation-adjusted terms, putting an increasing strain on the economy.

Higher and higher real rates could squeeze the economy just as it shows the first signs of moderation, and could even risk triggering a recession. Because the Fed wants to slow the economy just enough to curb inflation without slowing it so much that it causes a slowdown, officials want to avoid doing too much by simply doing nothing.

“Their focus right now is to maintain the soft landing,” said Julia Coronado, founder of MacroPolicy Perspectives. “So why risk tightening the policy? “Now the challenge is balancing the risks.”

Another important tool for understanding this moment in Fed policy is what economists call the “neutral” interest rate.

It sounds far-fetched, but the concept is simple: “Neutral” is the rate setting that keeps the economy growing at a healthy rate over time. If interest rates are above the neutral point, they should weigh on growth. If rates remain below neutrality, they should fuel growth.

This dividing line is difficult to pin down in real time, but the Fed uses models based on past data to locate it.

Currently, officials believe the neutral rate is in the neighborhood by 2.5 percent. The federal funds rate is around 5.4 percent, which is well above the neutral point even after adjusting for inflation.

In short, interest rates are high enough that authorities expect them to seriously weigh on the economy.

So why isn’t growth slowing more significantly?

It takes time for interest rates to have their full impact, and these lags could be part of the answer. And the economy has been slowed by some important measures. The number of job offers, for example, is constantly decreasing.

But as consumer spending and overall growth remain strong, Fed officials will likely remain cautious that rates may not weigh on the economy as much as they had anticipated.

“The last thing they want to do here is declare mission accomplished,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. “I think they’re going to be very careful about how they communicate that — and I think they need to be.”

The question is what the Fed’s reaction will be. So far, officials have suggested they don’t want to completely ignore rapid growth and want to avoid cutting rates too soon.

“Premature rate cuts could trigger a surge in demand that could initiate upward pressure on prices,” Raphael Bostic, president of the Federal Reserve Bank of Atlanta, said in a Jan. 18 speech.

At the same time, the current strong growth occurred when productivity improves: companies produce more with fewer workers. This could allow the economy to continue growing at a sustained pace without necessarily driving up inflation.

“The question is: can this be sustainable? said Blerina Uruci, chief U.S. economist at T. Rowe Price.

Ms. Uruci doesn’t think the strong economy will prevent Fed officials from initiating rate cuts this spring, although she thinks it will encourage them to try to keep their options open in the future.

“They have the advantage of not having to commit up front,” Ms. Uruci said of the Fed. “They need to proceed with caution.”