A hot economy isn't a good reason for the Fed to 'drag its feet' on rate cuts, former central bank economist says

• The Fed adds to recessionary risk if it stalls rate cuts, Claudia Sahm wrote in the Financial Times.
• High rates have already strained markets, and risk damaging the economy.

Strong labor and inflation conditions shouldn't stall interest rate cuts, and a higher-for-longer policy only compounds distress in the US economy, Claudia Sahm wrote in the Financial Times.

"From its start, this cycle has had little to do with the [Federal Reserve]. We are so close to unwinding the final Covid disruptions," the former central bank economist wrote. "Now it is not the time for the central bank to drag its feet on rate cuts. It is the time for the Fed to get out of the way."

Sahm, known for creating a recession indicator rule that shares her name, outlined that keeping rates at current levels only adds to recessionary risk.

The central bank's two-year hiking cycle has taken the fed funds rate from near-zero levels to a range of 5.25%-5.50%, and has already put pressure on a number of sectors.

For instance, housing market prices have jumped with the Fed's policy, given that mortgage rates loosely follow alongside interest rates. This has discouraged many homeowners from selling, and priced out prospective buyers.

Meanwhile, the sharp tightening has burdened both borrowers and lenders across financial markets. It's also punished unlucky business choices, as illustrated by last year's banking system turmoil.

Though not cited by Sahm, investors are now anxiously watching commercial real estate, as higher rates have made loans much more expensive to refinance.

"It's hard to say where the pockets of weakness are now, but the longer rates stay high, the more the Fed risks seriously damaging the economy," Sahm wrote.

Confronted with this, the central bank's reasons for holding rates steady aren't that convincing.

Generally, macroeconomic theory indicates that unemployment needs to rise for inflation to fall, which is what the Fed is waiting to see happen. It's for this reason that January's booming jobs market and inflation uptick have dampened rate-cut hopes.

But this relationship has become dubious, Sahm said, as inflation has fallen in 2023 while unemployment has remained below 4%.

"Instead, high inflation was largely due to Covid-related disruptions that are unwinding. Plus, 2019 had similar growth and unemployment along with less than 2% inflation," she said. "Finally, the Fed has a dual mandate of low inflation and low unemployment. Keeping rates high until the labor market cracks is not acceptable."

Though some support higher-for-longer policy on fears that inflation would re-surge if interest rates are cut too soon, Sahm argued that a need to adjust policy in the future wouldn't be norm-breaking.

"The world changes and so does policy. But the world has changed with notable disinflation, and the Fed is not changing its policy," she wrote.