Reasons behind the Fed’s unexpectedly bold rate reduction
The implications of the Fed’s unexpectedly bold decision to reduce interest rates warrant careful consideration. The members of the Federal Open Market Committee convened in Washington, assessed the economic landscape, and reached a near consensus. The Federal Reserve’s announcement on September 18 to initiate its easing cycle with a substantial 50-basis-point rate cut caught many off guard, myself included. However, just to a limited extent. In the days preceding the meeting, external sentiment was nearly evenly split between a conventional 25-basis-point increase and a more assertive 50-basis-point adjustment. The decision appeared sufficiently uncertain that either result would not have astonished observers of the Federal Reserve. I anticipated a 50 basis point increase but surmised that the more prudent committee would choose a 25 basis point adjustment.
This unexpected development offers insights into the Federal Open Market Committee’s dynamics, particularly regarding Chairman Jerome Powell’s perspectives. Three points. Initially, Mr. Powell, whose perspective holds significant weight, did not regard the decision as a mere toss-up. He appeared keen to initiate with a 50 basis point adjustment and, presumably, he influenced the committee towards that outcome. This conjecture is informed not only by his unexpectedly candid address in Jackson Hole, Wyoming, but also significantly by the dissent expressed by Michelle Bowman—the first from a Federal Reserve governor since 2005.
Mr. Powell undoubtedly recognized that she would oppose a 50 basis point increase, yet would likely support a 25 basis point adjustment. He values agreement and seeks to minimize disagreements. However, when faced with the decision between a unanimous increase of 25 basis points and a 50 basis point rise with a single dissent, he chose the latter. This conveys a significant insight. One implication could be that Mr. Powell is keen to avoid any delays from the Fed in the future. The FOMC has faced scrutiny for its delayed response to rising inflation, having only begun to raise rates in March 2022. Mr. Powell is keen to avoid a repeat of this narrative in 2024. It is important to note that there are significant delays between adjustments in interest rates and subsequent shifts in inflation rates.
In its assessment of the economic landscape, the FOMC determined that the employment aspect of its dual mandate faced more significant risks than inflation, particularly considering its policy rate, which stood at 5.25% to 5.5% prior to the September meeting. This occurs notwithstanding its statement from September 18 asserting that “the risks . . . are roughly in balance.” What leads me to this conclusion? It is important to note that neither of these two risks appears particularly significant or pressing at this moment. The 12-month inflation rate, gauged by the Federal Reserve’s favored personal consumption expenditures price index, has fallen from a high of 7.1% in June 2022 to 2.5% in the most recent assessment, positioning the Fed close to its 2% objective.
The unemployment rate, having reached a low of 3.4% in January 2023, has gradually risen to 4.2%. Nonetheless, this remains remarkably low by historical benchmarks and aligns exactly with the Federal Reserve’s present assessment of the unemployment rate indicative of “full employment.” By analyzing the current inflation and unemployment figures, it appears that the Federal Reserve is on the verge of accomplishing the elusive “soft landing.” However, a crucial variable continues to be misaligned: the Federal Reserve’s policy rate. Following the 50-basis-point reduction, the real federal-funds rate remains approximately 2.4% (4.9% less 2.5% inflation). Although estimates vary, there is a near consensus that the so-called “neutral” funds rate—often referred to as r*—is not as elevated as some might suggest. The Federal Reserve’s median projection stands at 0.9%. By that rudimentary assessment, it appears there remains approximately 150 basis points of potential rate reductions ahead—and possibly more should inflation continue its downward trajectory.
The decision to implement a more assertive increase of 50 basis points indicates that Powell and his colleagues remain undeterred by the influence of Donald Trump. The FOMC operates independently of political influences, and its decisions are grounded in economic considerations rather than political motivations. However, it was apparent that Mr. Trump would take issue with the more substantial rate cut, likely alleging that members were skewing the balance in favor of Kamala Harris. The former president undertook that action, albeit in a notably subdued manner by his usual standards. His focus appeared to be diverted, perhaps to Springfield, Ohio. Regardless, Mr. Powell is undoubtedly aware, unlike Mr. Trump, that a rate cut in September will exert only marginal influence on the economy by November.
Prior to the previous week, I contemplated the possibility of the Fed reducing rates once more on November 6. The day following Election Day may arrive without a clear indication of the victor. Political tensions are poised to escalate, potentially leading to more severe outcomes. In such an environment, the Fed would prefer to maintain a low profile. However, in light of the decision made on September 18, a further reduction in rates on November 6 appears probable, barring any contrary data developments.
