Stung by past mistakes, a wary Fed takes its time

On Wednesday, officials held rates steady and offered little evidence that they were prepared to begin lowering interest rates soon, as their counterparts in Canada and Europe began doing last week.

Most officials projected they could lower rates once or twice at four remaining meetings this year, suggesting a start to cuts no sooner than September—even after an inflation report earlier in the day suggested price pressures moderated last month.

“We’re looking for something that gives us confidence that inflation is moving sustainably down," Powell said at a press conference in which he used the word “confident" or “confidence" 20 times.

The European Central Bank and the Bank of Canada cut interest rates last week and indicated additional reductions were possible even though inflation remains above their targets—because they expect inflation to keep declining. “Overall, our confidence in the path ahead, because we have to be forward-looking, has been increasing over the last months," said ECB President Christine Lagarde last week.

But the U.S. is, for now, in a different position. Growth is stronger, and tight monetary policy might be transmitting more slowly to the economy. The U.S. financial system relies less on bank lending than in the past. Many homeowners are shielded from the rapid rate increases of 2022 and 2023 because they locked in ultralow rates on 30-year fixed-rate mortgages, which aren’t as prevalent elsewhere.

The Fed has also become focused on monthly inflation readings, because the economy, especially inflation, has proved difficult to forecast over the past three years, giving officials a possible case of PTSD.

In 2021, Fed officials held rates near zero despite a run-up in prices in the view—mistaken, in hindsight—that pressures would be short-lived.

“After an event like that, you’re going to be more worried about your credibility. You don’t want to make the same mistake twice," said Jan Hatzius, chief economist at Goldman Sachs.

Market- and survey-based measures of inflation expected in the future by households and businesses suggest “they have, by every metric, recouped their credibility, but they don’t want to take that for granted," said Julia Coronado, founder of economic-advisory firm MacroPolicy Perspectives. “They have set a slightly higher bar than other central banks."

Last year, the Fed and many private-sector economists expected that inflation would slow as growth weakened. They were right about inflation slowing down—but wrong about growth, which revved up.

Then in February and March, just as officials tacitly encouraged expectations that the Fed might cut rates in the coming months, progress on inflation stalled. “We got smacked in the face in the first quarter," said Coronado.

To be sure, the trust-but-verify approach risks putting the Fed in a catch-22. Powell and his colleagues are waiting until they have more convincing evidence that the Fed’s interest-rate setting is as restrictive as they think it is. But that raises the risk it will be too late to avoid a more serious employment downturn by the time they see that evidence, a point Powell acknowledged on Wednesday.

“We completely understand that that’s the risk—and that’s not our plan, to wait for things to break and then try to fix them," Powell said.

A series of inflation readings that are persuasively benign would liberate them from this trap. The alternative is for the Fed to wait to see more economic weakness before initiating rate cuts.

“I think they are looking for an opportunity to lower the policy rate, but obviously the wind has been blowing in the wrong direction," said James Bullard, a former St. Louis Fed president who is now dean of the Daniels School of Business at Purdue University.

Some Fed officials have indicated that once they start cutting rates, they plan to do so at regular intervals. In 1995, under Chairman Alan Greenspan, the Fed took a more idiosyncratic approach—cutting rates once in July and then waiting another 5½ months to reduce rates again. The Fed cut rates for a third and final time six weeks later, in January 1996.

Bullard favors a more “Greenspanian" approach that moves away from the idea that the initial move is “very momentous," he said. “What I’d advocate for is a technical adjustment that takes on board the idea that inflation is lower today than it was last summer."

Such a strategy more closely resembled the ECB’s latest move, which followed inflation numbers that were worse than expected and growth that has been stronger than expected, said Goldman’s Hatzius.

“Nevertheless, they’ve said, ‘We’re going to take a small step now. We’re not going to make a commitment to a major easing cycle,’" said Hatzius. “The Fed could eventually take that strategy, too."

Powell on Wednesday said the decision to cut rates would be a “consequential" one because it could ignite substantial market rallies that boost spending and investment. But he played down the idea that the exact month in which the Fed starts lowering rates by a quarter-percentage point, or 25 basis points, would matter as much.

“If you look back in five or 10 years and try to pull out the significance to the U.S. economy of one 25-basis-point rate cut, you’d have quite a job on your hands," he said.

Write to Nick Timiraos at Nick.Timiraos@wsj.com