The Fed aims to repeat Greenspan’s 1990s masterpiece
Summary
- The 1995 cuts helped lay the groundwork for a soft landing and the late ’90s boom years.
The Federal Reserve famously guided the economy to a soft landing in 1995, paving the way for the economic boom that followed. Can it do so again? With Wednesday’s sizable rate cut, it is off to a good start.
In 1994, the Fed raised rates aggressively to tackle inflationary pressures. By 1995, the labor market was clearly cooling. Then, as now, there weren’t signs of an imminent recession. But in May 1995 there was a negative reading for monthly jobs, helping push the Fed to the first of three cuts the following month.
That scary number turned out to be an anomaly—jobs bounced back the following month. But looking at a three-month moving average to smooth out volatility, the cooling trend was clear. In the three months through June 1995, the economy of that time had added an average of 126,000 jobs, down from an average of 332,000 in the three-month period a year before.
Fast forward to 2024: Jobs figures have again been bouncing around month-to-month, but in the three months through August, job creation averaged 116,000 a month, compared with 211,000 a year earlier.
The Fed’s three quarter-point rate cuts in 1995 and early 1996 succeeded: By mid-1996 job creation had rebounded to average around 250,000 a month, and inflation didn’t become a major concern for a long while after.
Why then has the Fed opted to start its easing program this time around with a more aggressive 50-basis-point cut? It isn’t, as some have fretted, that the Fed sees much bigger economic risks than the rest of us in the economy today. In fact, Fed Chair Jerome Powell sounded fairly positive in Wednesday afternoon’s press conference. “The U.S. economy is basically fine," he said. “Our intention is really to maintain the strength that we currently see in the U.S. economy."
Instead, it has to do with fundamental differences between the economy and the rate environment of the 1990s and those of today.
In 1995, the era of ultralow rates that began in the early 21st century hadn’t yet been dreamed of. When Alan Greenspan’s Fed started hiking rates in 1994, it brought them from 3% at the start of that year to 6% in February 1995. By contrast, in the Fed’s tightening cycle this time around, rates started at a range of between 0% to 0.25% in early 2022 and came all the way up to 5.25% to 5.5% by July 2023. The degree of tightening, in other words, was far greater this time.
The relative stance of policy is tighter as well. As TS Lombard economist Dario Perkins observed in a note this week, Greenspan had argued around 1995 that the so-called “neutral rate" was just three-quarters of a point below where the Fed was in June of that year. This is essentially the theoretical rate of interest that the Fed believes allows employment to be as high as possible while inflation is within target range. Three quarter-point cuts turned out to be just what the doctor ordered for the economy at the time.
While there is widespread debate over the current neutral rate, most economists believe it to be far lower, meaning the economy is less able to absorb high rates today than it was three decades ago. This could be due to a number of factors, including demographics, differences in productivity growth and changes to the financial system.
Powell on Wednesday said he doesn’t know what the current neutral rate is, except that he believes it is “significantly higher" than when it was around zero or even negative, such as at times before the pandemic.
Still, the “longer term" fed-funds rate forecast by Fed policymakers in their summary of economic projections gives some indication where the central bank believes it may be. This inched up to 2.9% in the latest projections from 2.8% in June. But that is still a long way from the current policy range after Wednesday’s cut to 4.75% to 5.0%.
What this means is that, following the postpandemic inflationary surge, the Fed has kept rates at what, by its own estimates, amount to extraordinarily restrictive levels. They have a long way to go to get them back to a level that isn’t holding the economy back. This helps explain not only why they opted to begin this easing cycle with a bang, but also why their projections imply two more quarter-point cuts this year and another full percentage point of reductions next year.
The Fed of the mid-1990s kept itself ahead of the curve and prevented a downturn. Powell’s Fed today is seeking to do the same. Considering where it is starting from, it has to move faster this time.
Write to Aaron Back at aaron.back@wsj.com
