Why I Supported Cutting Rates Last Week

Over the past few years, I have published a series of essays assessing where we are in our inflation fight and highlighting some important questions policymakers are facing. My most recent essay was in May of this year. In this update, I now explain why I supported the Federal Open Market Committee's (FOMC) recent decision to lower the target range for the federal funds rate by 50 basis points.

I argue that because we have made substantial progress bringing inflation back down toward our 2 percent target and the labor market has softened, the balance of risks has shifted away from higher inflation and toward the risk of a further weakening of the labor market, warranting a lower federal funds rate. While there remain mixed signals about the underlying strength of the U.S. economy and I remain uncertain just how tight policy is, I do believe policy remains tight today.

We've Made Substantial Progress Bringing Inflation Down

Earlier this year it appeared that disinflation might have stalled at around 3 percent. Since then, inflation has continued falling, and the increase in inflation in the first quarter appears to have been a bump, not a lasting trend.

The FOMC targets 12-month headline inflation of 2 percent. It now appears that while it remains too soon to declare victory in our inflation fight, we have made substantial progress, and the disinflationary process appears to be on track. You can see from the chart of three-month, six-month and 12-month core inflation that inflation appears on its way to returning to our target (see Figure 1).¹

The Labor Market Has Softened

Over the past six months, the labor market has shown signs of softening from the very tight conditions of the past couple years. Figure 2 shows the unemployment rate has climbed from exceptionally low levels a year ago to a still-low 4.2 percent in August. Meanwhile, job growth has slowed from an average of 251,000 per month in 2023 to 116,000 per month the past three months (see Figure 3).

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Other measures of the labor market also show signs of easing. For example, nominal wage growth has fallen from a peak of well above 5 percent in the spring of 2022 to a touch under 4 percent today (see Figure 4). And vacancies and quits have fallen to pre-pandemic levels, as shown in Figure 5.²

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Confusing Economic Signals Remain

The economy continues to offer mixed signals about its underlying strength. While a softening labor market suggests a weakening of economic activity, other economic measures suggest ongoing strength. For example, GDP and consumer spending continue to show surprising resilience, suggesting still-solid underlying demand (see Figure 6). Historically, the labor market has been a better real-time indicator of the health of the economy than measures of economic activity, which are reported with a lag and can be subject to material revisions. However, this surprising apparent economic resilience isn't completely new in this recovery. Even late last year, when most market participants expected a severe slowdown or even recession following the collapse of Silicon Valley Bank, the economy nonetheless delivered strong growth despite tight monetary policy.

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The Balance of Risk Has Shifted, Warranting Cutting the Federal Funds Rate

Given both the significant progress we've made in reducing inflation and also the softening of many labor market indicators, in my judgment the balance of risks has now shifted away from higher inflation toward higher unemployment. This could potentially jeopardize achievement of maximum employment. This risk assessment led me to support the FOMC's decision last week to reduce the federal funds rate by 50 basis points. As I argue in the next section, even after the 50 basis-point cut, I believe the overall stance of monetary policy remains tight.

The Path Ahead

In prior essays, I wrote that the single best proxy for the overall stance of monetary policy is the long-term real rate, specifically the 10-year Treasury inflation-protected securities (TIPS) yield. Focusing on a long-term rate incorporates the expected path of both the federal funds rate and balance sheet, not just the current level of the federal funds rate. Moreover, it adjusts the expected path of policy by expected future inflation-the relevant comparison-rather than by recently realized inflation.

As I noted in earlier essays, prior to the pandemic the 10-year real yield was about zero, which I estimate was roughly a neutral policy stance at that time. In response to the pandemic, the FOMC acted aggressively to support the economy by driving the federal funds rate to the effective lower bound and massively expanding our balance sheet. Those combined effects drove the 10-year real yield to roughly -1 percent, as shown in Figure 7. At the peak of our tightening cycle, the 10-year real yield peaked at around 2.5 percent. With the FOMC's recent action, that number has now fallen to around 1.6 percent. Thus, policy remains tighter now than immediately before the pandemic but has relaxed relative to its peak.

I have adjusted my submission to the Summary of Economic Projections as the data have changed (see Figure 8). I have slowly increased my estimate of the longer-run federal funds rate as we have continued to be surprised by the economy's resilience despite high policy rates, a combination that suggests the neutral rate may have climbed at least temporarily. The longer this economic resilience continues, the more signal I take that the temporary elevation of the neutral rate might in fact be more structural.

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How Might We Be Surprised?

One constant over the past few years has been economic surprises. As noted above, a year ago many market participants expected the economy to be near or in a recession for the second half of 2023. Thankfully that didn't happen, and instead we experienced strong growth combined with rapidly falling inflation as supply disruptions from the pandemic progressively unwound. At the end of 2023, it appeared that inflation was on its way to being defeated, and markets were then pricing in seven 25 basis-point rate cuts in 2024. We were then surprised by the bounce-back in inflation in the first quarter, which subsequently faded. So, I often ask myself: How might we be again surprised in the near future? I am focused on three specific risks:

1. Could recessionary forces be building in the background that will soon emerge to derail the recovery? Given lags with how monetary policy affects the economy, perhaps the economy is only now beginning to feel the full effects of tight policy. I see little evidence for this. In recent meetings with business leaders and organized labor representatives, I generally have heard cautious optimism about the underlying health of the economy and of their end markets. Of course, a recession can never be ruled out, but my contacts aren't seeing one around the corner.
2. Might inflation surprise us to the upside, disrupting the strong disinflationary process that currently appears underway? Again, I don't see much evidence for this. As Figure 9 shows, core goods inflation has returned to pre-pandemic levels. Core non-housing services inflation continues to fall and wage inflation continues to normalize, suggesting that non-housing services disinflation should continue. Housing inflation will take longer to fully normalize given the time it takes for leases to reprice. Most measures of new lease inflation suggest housing disinflation should continue over time, albeit slowly.³

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3. Might some new shock hit the economy? Certainly this is always possible and difficult to predict, given the wide range of sources of potential shocks. The COVID-19 pandemic and Russia's invasion of Ukraine are recent examples that we couldn't forecast. But given the data we have access to and the encouraging measures of activity, wages, and inflation, it seems as though a continuation of inflation moderation and economic resilience is the most likely scenario.

Conclusion

My colleagues and I on the FOMC are committed to achieving the dual mandate goals Congress has assigned us. In my judgment, cutting the policy rate by 50 basis points last week was the right decision-one that reflects both the substantial progress we've made in lowering inflation and also the softening of the labor market. Even after that cut, the overall stance of policy remains tight. Our path forward will depend on the totality of the incoming data for economic activity, the labor market and inflation. Ultimately this will guide us to where the policy rate eventually settles.

Endnotes

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