Back in 2021, legions of critics lambasted the Federal Reserve for failing to take proactive and forward-looking steps against the emerging inflation threat. Curiously, many of them have gone silent on the risk that the Fed might get caught flatfooted again, this time by failing to cut interest rates soon enough in the face of weaker inflation and a cooling labor market.
Lawrence Summers, the former US Treasury Secretary and a paid Bloomberg TV contributor, was perhaps the most notable critic of the “behind the curve” Fed a few years back. As recently as a few months ago, he was still warning against rate cuts and floating the idea that the central bank’s next move could be a hike. Summers isn’t an island unto himself, however, as about a third of economists surveyed by Bloomberg saw one or no cuts this year.
Consider the cross-section of monetary policy rules, which generate fed funds rate prescriptions based on standard economic variables. Just as they showed that the Fed was behind the curve in 2021 and 2022, four of the five common policy rules — including the classic 1993 Taylor Rule — now suggest policy rates below the current 5.25%-5.5% range. The core personal consumption expenditures deflator — the Fed’s preferred gauge — puts year-over-year inflation at just about 2.6%, less than half of the peak rate of 5.6% in February 2022. While that’s still technically above the Fed’s 2% target, the current policy stance implies a lot of medicine for what’s become a relatively mild ailment.
Among the Fed’s top leaders, the goal of forward-looking monetary policy is uncontroversial. The question, however, is how one can put forward-looking policy into practice while also remaining beholden to backward-looking data. Here’s how Chair Jerome Powell tried to explain this dance at an Economic Club of Washington event, in conversation with Bloomberg host and Carlyle Co-Chairman David Rubenstein (emphasis mine):
Rubenstein: The Fed has set a target for inflation of 2%. Now, can you clarify? Does that mean that the inflation rate has to be at 2% before you’re ready to move, if you are ready to move? Or does it have to be within sight? And what does it mean to be within sight?
Powell: So, when we change interest rates, that tightens financial conditions and that, in turn, affects economic outcomes — you know, growth, labor markets and ultimately inflation, but with lags that can be long and variable, as Milton Friedman famously said. And the implication of that is that if you wait until inflation gets all the way down to 2%, you’ve probably waited too long. Because the tightening that you’re doing — the tightness that you have — is still having effects which will probably drive inflation below 2%. So we’ve been very clear that you wouldn’t wait for inflation to get all the way down to 2%. Our test has been for the past quite some time that we wanted to have greater confidence that inflation was moving sustainably down toward our 2% target, and what increases that confidence is more good inflation data. And lately we have been getting some of that.
In fairness, Powell has navigated the risks extremely well since mid-2022, and he deserves a lot of credit for putting the American economy in a position to achieve a rare “soft landing.” But he still has to stick it, and there are a number of problems with the “test” that he described.
First, there’s room for debate about where underlying inflation actually sits today. The oft-sighted year-over-year figure, of course, is a function of base effects from 12 months earlier. On a three-month annualized basis, core PCE appears to already be below 2%, based on Bloomberg Economics’ estimates for the yet-to-be released June data. Many of us have also argued that the entire housing component of inflation feels a lot like yesterday’s news. If you cut it out of the index, year-on-year core PCE inflation is under 2%. I’m not advocating that anyone exclusively use those bespoke slices of the data, but you have to take them into consideration at key inflection points like this one.
Second, there’s room for debate about what, exactly, would give the Fed “greater confidence that inflation was moving sustainably” toward target. I appreciate the spirit of this Powellism because many of us were head-faked by earlier improvements in the inflation data. But we’ve just had three great reports. And the government data has now hit the mark in about 8 of the past 12 months, lending less weight to the first-quarter numbers that weren’t so pristine. In a data series that’s inherently imperfect and noisy, that strikes me as enough.
Personally, that’s why I’ve been in the July rate-cut camp since the immaculate consumer price index report on July 11. As I said at the time, I still have serious doubts that the Fed will listen, primarily because they’ve convinced themselves that they can, indeed, be simultaneously “forward looking” and “data dependent.” They also seem to believe that they have to spend weeks priming the markets for their first move through subtle smoke signals in the Fed’s policy statement and, probably, through a series of speeches — giving modern markets too little credit.
Meanwhile, the unemployment rate has climbed in each of the past three months. To be sure, the unemployment drift owes itself largely to labor market entrants, reentrants and relatively weak hiring, and layoffs remain very low. But history has shown that labor market trouble can snowball in a hurry. So why take the chance?
A cut at the following meeting in September probably wouldn’t be the end of the world, but waiting introduces the risk that the window of opportunity could close. In a July 15 note titled “Why Wait?,” Goldman Sachs Group Inc. Chief Economist Jan Hatzius also observed that inflation data — while encouraging now — is inherently volatile. If policymakers wait, he said they may find that the data won’t cooperate, and the rate reduction could be “awkward” to explain. Then what, November? Hatzius also noted that the September meeting would come right before the presidential election, and policymakers may want to avoid the perception of putting their thumb on the scale.
Ultimately, they shouldn’t get caught waiting for a perfect opportunity when it might never arrive. Hatzius summed it up best: “If the case for a cut is clear, why wait another seven weeks before delivering it?”
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