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— Bloomberg
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SHOULD the US Federal Reserve (Fed) keep cutting interest rates? Markets certainly think it will: Futures prices suggest the federal funds rate will fall to about 3% by the end of 2026, from just above 4% now.
I’m not so sure that would be a good idea.The arguments for cutting rates fall into three buckets.
1) Risk management: Chair Jerome Powell has made this case, saying that the upside risk to inflation no longer outweighs the downside risk to the labour market, with job growth slowing sharply and the price impact of tariffs likely to be temporary.
It assumes that monetary policy is “moderately restrictive”, and hence should move towards a more neutral stance. This is reflected in Fed policymakers’ near-unanimous decision to cut interest rates last month – even as they raised their median growth and inflation forecasts.
I’m not convinced. Inflation might still be the greater risk. The Fed has exceeded its 2% inflation target for more than four and a half years and is missing that target by a greater margin than its employment objective.
The pass-through of tariffs into prices, while slower and less substantial than expected, is far from over. And monetary policy might not actually be all that restrictive: Recent economic data indicate that demand has strengthened, with the Atlanta Fed Gross Domestic Product Now model forecasting 3.8% annualised growth in the third quarter.
2) Anticipation: As governor Michelle Bowman argued in a recent speech, if the Fed waits for data to confirm a further deterioration in the labour market, it might be too late. So the Fed must act preemptively.
I agree that policy should be preemptive – but only if one has adequate confidence in one’s forecast. Right now, the economic outlook is highly uncertain: It’s impossible to know whether to worry more about inflation becoming entrenched and inflation expectations less well-anchored, or about the labour market deteriorating substantially.
So there’s a risk preemptive action will prove to be a costly mistake.
3) Estimation error: By this logic, which Fed governor Stephen Miran has espoused, monetary policy is actually much tighter than the Fed thinks, because the neutral interest rate – the rate that neither damps nor stimulates growth – has fallen considerably.
Among the reasons Miran has cited to believe this: Slowing population growth will reduce the demand for capital to equip and house people, tariff revenue will reduce government borrowing, and tax cuts will increase national saving.
I agree with the point on population growth, but the rest seems selective at best. If, for example, tax policy reduces the effective cost of capital, shouldn’t this increase investment demand relative to savings, and hence increase the neutral rate?
Won’t the higher deficits generated by the Big Beautiful Bill require more government borrowing, at a time when the Trump administration’s trade policies have reduced demand for US dollar-denominated debt? If the neutral rate were actually zero (adjusted for inflation), as Miran asserts, then the current higher rates should be crushing the economy. We’re not seeing that.
In short, I think the Fed has plenty of reason to worry, but not enough to act. The labour market is a legitimate concern: When it deteriorates beyond a certain threshold – defined by the Sahm rule as a 50-basis-point increase in the unemployment rate – the weakness tends to be self-reinforcing, triggering a full-blown recession.
The threshold was breached last year without incident, probably because the rise in unemployment was generated by a surge in the labour force, not by less hiring.
This time around, the driver would be weak demand for workers because the crackdown on immigrants is causing a collapse in labour force growth.
Yet if inflation remains a percentage point or more above the Fed’s 2% mandate, expectations could become unanchored.
If this happened, the cost of getting prices under control – in terms of the rise in the unemployment rate required to hit the 2% target – would grow markedly. Back in the 1970s, that cost proved to be two back-to-back recessions and a sharp jump in unemployment.
I believe that Fed officials will cut interest rates again at their policy-making meeting this month.
They’re not likely to see much that changes their assessment from the last meeting – particularly given that, thanks to the government shutdown, there might be very little new data to evaluate.
But I doubt this is the right course, or should foreshadow a long easing cycle. I’d favour a more cautious approach until the economic outlook becomes less cloudy. — Bloomberg
Bill Dudley is a Bloomberg Opinion columnist. The views expressed here are the writer’s own.
Article by: Bill Dudley
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