The Fed’s High Wire Act
Again, the Federal Reserve (Fed) has gambled and again it deserves attention. With two interest rate cuts totaling 75 basis points (hundredths of a percentage point) since September, it and its chair, Jerome Powell, have effectively announced the balancing of two policy judgements. Neither is secure. One is that inflation, though still running above the Fed’s preferred target range of 2.0 percent a year or lower, is acceptably quiescent and will soon slide into the target range, presumably of its own accord or as a lagged response to past monetary restraint. The second is that the Fed needs to ease the economic fetters implicit in past monetary restraint in order to secure a soft landing for the economy, that is to avoid a recession. By the Fed’s December meeting, this balancing act promises to reach a critical juncture, a prescription for extreme policy caution.
When the Fed made its first interest rate cuts this past September, matters required less attention to balance. Then it seemed that the Fed had succeeded in bringing inflation down from its highs to a sustainable rate of less than 3.0 percent a year, still above target but much less troubling than in earlier months. At the same time, the economy was showing signs of weakening, and some market participants and economists were talking about recession. Against this mix of circumstances, an interest rate cut must have seemed an easy choice. A cut of 50 basis points instead of the usual 25 basis points was a bold move, but not especially risky given the economic and inflation background at the time.
By November, however, the balance of signals had changed. Inflation was still quiescent, but with the Fed’s preferred measure, what is referred to as “core PCE” (consumer inflation less food and energy) had made little progress toward the preferred target range and seemed to have settled at a 2.7 percent annual rate. What is more, inflation measures were showing that down was not its only direction for inflation. The measures for July, August, and September, the most recent figure available when the Fed met in November, were all up slightly from the readings in May and June. The differences were not enough to make a policy argument, but the news was sufficient to give pause, or should have been. At the same time, the economy signaled that it needed less help than seemed to be the case in September, when the Fed first cut interest rates. Indeed, Powell himself noted that “the economic activity data have been stronger than expected.” Nonetheless, the Fed acted as though there was no change in the mix of indicators. It took a risk and cut interest rates an additional 25 basis points.
Now looking into December, another cut would seem to put the Fed in still riskier territory. Except in the unlikely event that inflation securely entered the Fed’s preferred target range, or the economy suddenly showed alarming signs of weakness, such a move would be entirely unjustified. It would effectively announce that the Fed had given up on moving inflation back into the preferred target range and that it was ready to seek economic stimulus regardless of the economy’s immediate needs. That would be a remarkable step after an almost three-year stretch in which the Fed conducted a seemingly successful or near successful fight to bring inflation down to preferred levels.
It would also raise the chance that the Fed would have to reverse policy again if inflation were to pick up, an event that cannot yet be dismissed. Such a reversal of policy would embarrass the Fed and be an especially bad situation for Chairman Jerome Powell, who will be fighting the new White House to keep his post in the new year.
This unfolding balance has begun to show in market indicators. Although the Fed’s own long-term interest rate forecast indicate cuts totaling 125 basis points over the course of 2025, that is five 25 basis point cuts, the yield curve, which all but agreed with this forecast only some weeks ago has adjusted so that it now anticipates only one or two more additional 25 basis point cuts over the coming twelve months. In another sign of market expectations, the CME Group’s FedWatch tool, had last September indicated that there was zero chance the Fed would fail to make several rate cuts over the next six months. Now the tool indicates a 17 percent chance of only one additional cut during that time. Seventeen percent is still a low probability, but set against zero a few weeks ago, this measure captures the direction of change in market attitudes and expectations.
Policy decisions are always taken amid uncertainty. They are implicitly a forecast, and as the great Yankee catcher Yogi Berra said, “forecasting is hard especially when it is about the future.” But not all futures are as murky as others. Last September, the Fed’s way forward seemed almost obvious, even if it was not entirely secure. Policy makers could act decisively, and they did with that 50-basis point interest rate cut. Matters were less clear earlier in November, and without a radical change in economic and inflation signals, they will be murkier still later in December and early 2025. The Fed will then likely show much more caution. Economic and inflation signals will demand it, and so will the prospect of the new president set to play a game of gotcha with Chairman Powell.
