The US Federal Reserve (the Fed) conducts monetary policy according to a dual mandate, legislated by Congress, to achieve stable prices and maximum employment. The Fed has defined price stability as the annual rate of inflation measured by the ‘core’ (i.e., non-food, non-energy) personal consumption expenditure price index of 2.0%. The Fed has never precisely specified its measure of ‘maximum employment’, though that aim is broadly perceived to be an unemployment rate near 4.0%.
When the Fed’s twin objectives have been met, monetary policy should be neither restrictive nor accommodative. Under those circumstances, the Federal Reserve should set its target Fed funds rate at its ‘neutral’ level.
Today, core PCE inflation is 2.6%, down from a post-pandemic peak of 5.6% in February 2022. Excluding shelter price inflation, which reflects house prices with long lags and is therefore a flawed representation of current inflation conditions, core inflation has now arrived at its 2.0% target rate.
The US unemployment rate, at 4.2%, is above its cycle low of 3.5%, but the increase in the jobless rate this year largely reflects more Americans willing to work. Taken together, the US unemployment rate and the labor force participation rate are widely considered to be in the vicinity of ‘maximum employment’ for the US economy.
In short, as of September 2024 the Federal Reserve has achieved its dual mandate of price stability and maximum employment.
Great. But there is one problem. The prevailing Fed funds rate of 5.25-5.50% is nowhere close to its ‘neutral’ level.
Now, to be sure, there is plenty of disagreement among economists and central bankers about where neutral resides. Some place it close to 4.00%, others more like 2.50%. Others think it may be even lower. But no one disputes that the Fed’s current setting is restrictive.
Accordingly, everyone—including one imagines all 12 voting members of the Federal Reserve’s Open Market Committee (FOMC)—believes the Fed will cut interest rates at its upcoming September 17-18 FOMC meeting.
But that is where agreement ends.
Traditionally, when the Fed eases during times free from excessive economic or financial stress, as is the case today, it proceeds gradually, cutting interest rates in quarter-point (25 basis point) increments over many months. Indeed, many observers (roughly half of market participants according to various metrics) believe the Fed will adhere to convention and cut rates on September 18 by a quarter point.
Others, however, fear the Fed has already delayed easing too long. They point to a rise in the unemployment rate, slowing jobs growth, indications the manufacturing sector is contracting, falling commodity prices, and tumbling bond yields as signs that the Fed’s restrictive stance, alongside other factors such as a fatiguing US consumer, could be pushing the economy already toward an unwelcome slowdown, perhaps even a recession. They are calling for the Fed to slash rates next week by 50 basis points.
But why stop there?
If, as noted, the Fed has now achieved its dual mandate and the prevailing Fed funds rate is at least 125-150 basis points above the highest plausible estimates of its neutral level, why not get to the neutral setting in one fell swoop with, say, a 150-basis point cut on September 18?
Wouldn’t that make more sense that taking 36 weeks (six quarter point cuts at each of the next six FOMC meetings) to get there? Isn’t it a violation of the Fed’s Congressional mandate to ease gradually and therefore remain restrictive for longer, potentially putting the economy and jobs at risk, when it could get to its neutral setting instantaneously?
The truth is, no one—and I mean not a single experienced Fed watcher—believes the Fed will do anything but take its time to get back to a neutral monetary policy. Acting all at once is a fantasy.
But the question remains, why? Why will the Fed plod ahead rather than respond with logical boldness, particularly if going slowly poses significant risks to the economy, jobs, and livelihoods?
One commonly offered answer is that a big, bold rate cut could stoke inflation.
But that flies in the face of the evidence that inflation in this cycle was primarily driven by supply-side rigidities, most of which have been alleviated, not by excess demand. Equally, that argument ignores today’s warning signs provided by falling bond yields, tumbling commodity prices, dipping measures of expected inflation, and wobbles in global equity markets as evidence that investors are more anxious about US economic growth. It also ignores what Fed Chairman Powell emphasized in his speech last month at Jackson Hole, namely that the risks to the US economy have shifted from inflation to growth.
So, if inflation is not the reason to ‘go slow’, what is?
The most plausible answer is that a massive interest rate cut could unleash concerns on Wall Street and Main Street that something is fundamentally awry in the financial sector or the economy, that the Fed ‘knows’ something the rest of us don’t.
But that suggests the Fed is handicapped from doing the right thing by an inability to explain itself. If one argues that the Fed can’t possibly cut rates by 150 basis points next week because it might roil the markets or spread fear in the public, the implication is that the Fed is trapped into sub-optimal policy decisions by its inability to speak clearly or to be taken seriously.
Sadly, the Fed appears shackled by a communications problem of its own making. For years, the Fed has prized predictability, using its speeches, written texts, and press conferences to guide investors and citizens along a smooth path of adjustments to monetary policy. That approach has been largely successful over decades of refinement.
But sometimes circumstances call for unconventional approaches. It would be a shame, and worse, if the livelihoods of millions of Americans were sacrificed to convention when a clear alternative exists.
The eminently quotable John Maynard Keynes captured the spirit of what the Fed risks when he sarcastically quipped:
“Worldly wisdom teaches that it is better for reputation to fail conventionally that to succeed unconventionally.”
The Fed is flirting with putting the economy at risk by acting conventionally. Might it try for unconventional success instead?
I wish they would, but I’m not counting on it.