The Fed’s Rate Cut Thinking

The Federal Reserve made a relatively large reduction in short-term interest rates at its September 2024 meeting. They were not, though, in a panic or worried about an imminent recession. Instead, they were thinking that the old interest rate would not be appropriate going forward. That’s a very sensible position.

The phrasing of Jerome Powell’s statement to the press is telling: “Today, the Federal Open Market Committee decided to reduce the degree of policy restraint by lowering our policy interest rate by 1/2 percentage point.” He did not say they were shifting to an easier monetary policy, but merely reducing restraint. That’s a critical distinction.

The economy has been strong. Growth of gross domestic product (GDP) was above trend last quarter and unemployment below its long-run average, though somewhat above its pre-pandemic reading.

The Fed, however, believes that the previous Federal Funds interest rate, 5.33% was restrictive. Bringing it down to 4.83% is simply less restrictive. What they don’t know, however, is what exactly is the neutral interest rate. They presume that a neutral rate exists, but they cannot see it in real time. In fact, they can look at rough estimates of past values, and they don’t believe it’s steady over time. But they are pretty sure it’s below the current rate.

Referring to the Fed as if it’s of one mind is certainly wrong (though occasionally useful). For the long-run tendency of the Fed Funds rate, the 19 members of the Federal Open Market Committee (FOMC) had 11 different answers, spread from 2.375% to 3.75%.

Adding to the Fed’s difficulty is uncertainty about the time lags in monetary policy. Milton Friedman famously concluded that the lags were long and variable. Estimation of the time lags from historical data is confounded by structural changes in the economy. The financial system has evolved in recent decades, as has the role of international trade, the importance of services relative to goods production as well as economists’ understanding of the economy.

Saying that the Fed is “flying blind” relative to the neutral rate and the time lags may be an overstatement, but “visibility impaired” would be entirely accurate.

Although the FOMC vote had one dissent in its latest decision (Michelle Bowman who argued for cutting rates by a quarter percent rather than a half), the Fed has greater differences than their final vote shows. Joseph C. Sternberg recently wrote in The Wall Street Journal, “The Fed seems skittish about the idea that the children on Wall Street might see the parents arguing in Washington.”

Nonetheless, the is a general consensus on two points: that the Fed has made progress against inflation, and that the labor market is not as strong as it recently was.

The inflation performance is undeniable, with the Fed’s preferred measure of inflation dropping from 5.6% in early 2022 to 2.6% in the July reading. (August data are not yet available.) The Fed also thinks that they have more improvement in the pipeline. Remember those time lags. If the old interest rate was restrictive, then additional drops in inflation should be coming, even if the Fed shifts to neutral now. The fact that they believe that interest rates are still restrictive, just less so, means that they really want inflation to come down more.

Great concern about inflation must come from the huge federal deficits being rung up, with more deficit spending on the way regardless of the presidential election. Economists argue among ourselves about the effect of deficits on inflation, but even the slightest role for deficits would imply the Fed needs to keep interest rates restrictive for quite a while.

While inflation has come down, the employment side of the Fed’s “dual mandate” has turned less hot. Not only is unemployment a little higher than two years ago, but the number of voluntary quits and open job positions have both fallen. Neither is flashing warnings signs, but they are not super-strong anymore. Initial claims for unemployment insurance, a decent leading indicator of the overall economy, has increased since the first of 2024, though it’s well below long-run average.

The Fed believes—and I agree—that the economy is strong, but in a middle ground going forward. They are likely to continue cutting interest rates through this year and the end of 2025, but what happens after that is a wide open question.