Calls for Rate Cuts Grow as Fed Grapples with Inflation Risks & Weaker Job Market
By Jim Clouse
The Federal Reserve’s September policy meeting is shaping up to be one of the most interesting and consequential meetings in some time with significant risks to both sides of the central bank’s dual mandate.
Inflation has continued to run stubbornly above the Federal Open Market Committee’s (FOMC) 2% objective, and many forecasters anticipate that tariffs will put continued upward pressure on inflation over coming months. Meanwhile, the pace of economic growth has moderated this year, and the most recent employment report was weaker than anticipated with substantial downward revisions to employment growth in the second quarter.
The policy rate is currently set at 4.25% to 4.5% and there is no shortage of backseat drivers offering advice to the FOMC on what the right setting should be to achieve the Fed’s goals of stable prices and maximum employment. This blog will look at some of these recommendations in light of a suite of models. Almost none of them have results that are as low as some administration officials suggest. However, the policy rate prescriptions don’t incorporate the weaker July employment report, which also included sharp downward revisions for May and June. As we will note, risks to the labor market are certainly one reason why Fed officials may favor cutting the target range for the federal funds rate.
The president and other administration officials have suggested that the federal funds rate should already be 100 basis points or more below its current level, while two governors dissented in July in favor of a quarter point cut. Futures markets quotes show market participants pricing in around an 85% probability of a quarter-point reduction to a range of 4% to 4.25%.
Inflation has continued to run stubbornly above the Federal Open Market Committee’s (FOMC) 2% objective, and many forecasters anticipate that tariffs will put continued upward pressure on inflation over coming months. Meanwhile, the pace of economic growth has moderated this year, and the most recent employment report was weaker than anticipated with substantial downward revisions to employment growth in the second quarter.
The policy rate is currently set at 4.25% to 4.5% and there is no shortage of backseat drivers offering advice to the FOMC on what the right setting should be to achieve the Fed’s goals of stable prices and maximum employment. This blog will look at some of these recommendations in light of a suite of models. Almost none of them have results that are as low as some administration officials suggest. However, the policy rate prescriptions don’t incorporate the weaker July employment report, which also included sharp downward revisions for May and June. As we will note, risks to the labor market are certainly one reason why Fed officials may favor cutting the target range for the federal funds rate.
The president and other administration officials have suggested that the federal funds rate should already be 100 basis points or more below its current level, while two governors dissented in July in favor of a quarter point cut. Futures markets quotes show market participants pricing in around an 85% probability of a quarter-point reduction to a range of 4% to 4.25%.
Start With A Rule
Policymakers will review a wide range of issues in reaching a decision about the stance of policy at the September meeting. As a starting point, they may take a look at the policy rate prescriptions of simple policy rules. These rules relate the appropriate setting of the federal funds rate to a small set of economic variables such as inflation and the unemployment rate. To be sure, simple policy rules have their shortcomings. By design, they capture only a small subset of the economic information that informs policy decisions and notably do not take account of important risks to the outlook. However, simple policy rules embed some key principles of sound monetary policy and tend to perform well in producing good economic outcomes across a wide range of models and economic shocks.
The Federal Reserve Bank of Cleveland provides a useful summary of selected rules on its website Simple Monetary Policy Rules. The table above reports the results from seven different policy rules using three different sets of economic forecasts.
While there are some prescriptions that are considerably lower than the current level of the federal funds rate, the median and interquartile range of the funds rate prescriptions for Q2 and Q3 of this year — shown at the bottom in red — are right around the current level of the federal funds rate.
The Federal Reserve Bank of Cleveland provides a useful summary of selected rules on its website Simple Monetary Policy Rules. The table above reports the results from seven different policy rules using three different sets of economic forecasts.
While there are some prescriptions that are considerably lower than the current level of the federal funds rate, the median and interquartile range of the funds rate prescriptions for Q2 and Q3 of this year — shown at the bottom in red — are right around the current level of the federal funds rate.
A One Time Increase?
As always, policymakers will take many factors in addition to policy rule prescriptions into account in their deliberations. In September, it seems likely that the issue of “looking through” one-time increases in the price level and “risk management considerations” more generally will be a focus of conversation.
On the issue of looking through one-time price increases, most economic forecasters expect some upward pressure on prices over the remainder of this year stemming from higher tariffs. If this upward pressure on prices is short-lived and does not feed through to an increase in longer-term inflation expectations, some will argue that it makes sense to focus more on an “underlying” rate of inflation that strips out the effect of one-time factors.
Moreover, given the significant lags in the transmission of monetary policy to the economy, there is relatively little that policymakers could do now to damp a temporary, tariff-induced pickup in inflation over the coming months.
All else equal, the “looking through” logic might suggest a move to a more accommodative stance of monetary policy. Indeed, the low funds rate prescription from the “forward looking rule” in line 19 of the table reflects a forecast that inflation will be close to 2% in a few quarters.
On the issue of looking through one-time price increases, most economic forecasters expect some upward pressure on prices over the remainder of this year stemming from higher tariffs. If this upward pressure on prices is short-lived and does not feed through to an increase in longer-term inflation expectations, some will argue that it makes sense to focus more on an “underlying” rate of inflation that strips out the effect of one-time factors.
Moreover, given the significant lags in the transmission of monetary policy to the economy, there is relatively little that policymakers could do now to damp a temporary, tariff-induced pickup in inflation over the coming months.
All else equal, the “looking through” logic might suggest a move to a more accommodative stance of monetary policy. Indeed, the low funds rate prescription from the “forward looking rule” in line 19 of the table reflects a forecast that inflation will be close to 2% in a few quarters.
Managing Risk
However, other policymakers have noted that the looking-through logic relies on a great deal of confidence about the nature of the “one time” increase in prices associated with unprecedented increases in tariffs. After all, oil price shocks in the 1970s were supposed to be one-time price increases too.
If tariff-induced upward pressure on prices proves to be persistent, and especially if it feeds through to longer-term inflation expectations, policymakers will likely maintain a more restrictive stance of monetary policy for longer.
Unfortunately, no one has a crystal ball and decisions about the stance of policy in the current environment of high uncertainty will almost certainly take “risk management” considerations into account.
There is a science about monetary policymaking under uncertainty but the practice of policymaking under uncertainty also involves a lot of “art” in the form of policymaker judgement about the likelihood and costs of various scenarios.
If tariff-induced upward pressure on prices proves to be persistent, and especially if it feeds through to longer-term inflation expectations, policymakers will likely maintain a more restrictive stance of monetary policy for longer.
Unfortunately, no one has a crystal ball and decisions about the stance of policy in the current environment of high uncertainty will almost certainly take “risk management” considerations into account.
There is a science about monetary policymaking under uncertainty but the practice of policymaking under uncertainty also involves a lot of “art” in the form of policymaker judgement about the likelihood and costs of various scenarios.
Ditches and Cliffs
A theme that often emerges is the potential to adjust the stance of policy to provide some insurance against especially adverse outcomes. To take a familiar example, if you’re driving on a slippery road with a shallow ditch on one side and a steep cliff on the other, most people would drive closer to the side with the shallow ditch.
At the September FOMC meeting, it seems likely that some of the discussion will focus on the nature of the cliff and the shallow ditch in current circumstances. The more hawkish participants may point to the cliff of persistent inflation and unanchored inflation expectations amid very accommodative financial conditions, perhaps noting that the U.S. economy was totaled in driving off that cliff in the late 1960s and 1970s.
The shallow ditch for these participants would be the risk that maintaining modestly restrictive policy results in sluggish growth and a moderate upturn in the unemployment rate. Balancing those risks, these participants may wish to maintain a modestly restrictive stance of monetary policy for the time being.
The more dovish participants may point to a cliff in which overly restrictive policy leads to recession dynamics with severe consequences in the labor market and a sharp tightening in financial conditions. The shallow ditch for these participants might be the risk that more accommodative policy proves unnecessary and results in some additional modest upward pressure on inflation. Balancing those risks, these participants may wish to to ease policy at the upcoming meeting and signal a return to a more “neutral” policy stance in the neighborhood of 3% over the near-term.
In the end, whether the FOMC leaves the federal funds rate unchanged at the September meeting or implements the quarter-point easing anticipated by market participants matters less than any signals the FOMC provides about the path of policy going forward.
On that score, Chair Powell’s comments at this week’s annual monetary policy conference in Jackson Hole may provide some clues about how he and his FOMC colleagues are now viewing the balance of risks to the economic and policy outlook.
At the September FOMC meeting, it seems likely that some of the discussion will focus on the nature of the cliff and the shallow ditch in current circumstances. The more hawkish participants may point to the cliff of persistent inflation and unanchored inflation expectations amid very accommodative financial conditions, perhaps noting that the U.S. economy was totaled in driving off that cliff in the late 1960s and 1970s.
The shallow ditch for these participants would be the risk that maintaining modestly restrictive policy results in sluggish growth and a moderate upturn in the unemployment rate. Balancing those risks, these participants may wish to maintain a modestly restrictive stance of monetary policy for the time being.
The more dovish participants may point to a cliff in which overly restrictive policy leads to recession dynamics with severe consequences in the labor market and a sharp tightening in financial conditions. The shallow ditch for these participants might be the risk that more accommodative policy proves unnecessary and results in some additional modest upward pressure on inflation. Balancing those risks, these participants may wish to to ease policy at the upcoming meeting and signal a return to a more “neutral” policy stance in the neighborhood of 3% over the near-term.
In the end, whether the FOMC leaves the federal funds rate unchanged at the September meeting or implements the quarter-point easing anticipated by market participants matters less than any signals the FOMC provides about the path of policy going forward.
On that score, Chair Powell’s comments at this week’s annual monetary policy conference in Jackson Hole may provide some clues about how he and his FOMC colleagues are now viewing the balance of risks to the economic and policy outlook.
