On My Mind: For a few rate cuts more

The latest US employment report provided an unequivocal verdict: The labor market is still strong, as Federal Reserve (Fed) Chair Jerome Powell stressed in the September press conference. Nonfarm payrolls blew past expectations, with over 250,000 jobs created in September and upward revisions to previous months. The unemployment rate edged back down to 4.1%, which by most estimates is below the natural rate. The participation rate remained constant, so lower unemployment reflects more people getting jobs, not dropping out of the labor force. Wage growth also exceeded expectations, and the three-month moving average is running at 4.3%, too high for the Fed’s 2% inflation target. This comes after macroeconomic data surprise indices had already turned positive again.

The repeated demonstrations that the economy remains stubbornly resilient have opened a more two-sided debate on the level of the neutral policy rate. I expect that more market observers will gradually come around to my long-held view that this monetary policy easing cycle will likely be short and shallow, because the current policy setting is not overly restrictive to start with.

I thought a 25 basis-point (bp) rate cut in September would have been enough, and this latest data seem to confirm it. The Fed decided to cut 50 bps—which was not the end of the world, of course. The problem, I warned, was that markets risked getting ahead of themselves, pricing another full 50 bps for the remainder of the year. Now it looks quite possible that the Fed will instead decide to hold rates at one of the two remaining policy meetings for 2024, delivering only an extra 25 bps. The reason, I believe, is that it’s becoming increasingly clear that the need and the scope for further monetary easing is limited.

Let’s take a step back. When inflation started rising over three years ago, I argued against the consensus view that we faced just a “transitory” spike entirely driven by supply shocks. I thought there were more durable pressures at work, including very loose financial conditions and an extremely expansionary fiscal policy, both feeding excess demand.¹ When the Fed finally started raising rates in March 2022, after inflation had doubled to about 8%, I thought that the planned tightening (less than three percentage points [pp] based on the “dots,” starting from a zero fed funds rate) was nowhere near enough to address the inflation challenge² Indeed, the fed funds rate has peaked at 5.25%-5.50%, over 2.5 pp above what the Fed envisaged.

The inflation surge had brought a crucial message: The period of zero interest rates and low inflation that started with the global financial crisis (GFC) and extended through the COVID-19 pandemic was not a new normal: it was an historical anomaly that had come to an end.³ It was time to switch gears and reset our expectations for a world heading back to the pre-GFC norms.

My long-held view on the outlook for policy rates and market yields rests on two pillars, as I discussed in detail in August of last year.⁴ The first is that the neutral rate of interest is probably somewhere north of 4%, in line with the long-term average preceding the GFC, implying a fair value for longer- term US Treasury yields of 5.0%-5.5%. The second is that loose fiscal policy continues to fuel demand and sets the conditions for future upward pressure on bond yields, through steadily increasing government financing needs.

Over the past year, Fed policymakers have been gradually acknowledging that the neutral rate is higher than they thought. Back in July 2022, after lifting the fed funds rate to 2.25% Powell argued that at 2.25% the fed funds rate had reached its neutral range—needless to say, I strongly disagreed.⁵ Now the Fed’s median forecast for the natural policy rate is 2.9%, and the upper end of their forecast range (2.4%-3.9%) is very close to my estimate.

But with the Fed indicating that policy rates would eventually revert to very low levels, at every weak data release financial markets have repeatedly anticipated a significant monetary easing, pushing asset prices up. The resulting easing in financial conditions offset much of the policy tightening effort, turning the Fed into a modern Sisyphus. This problem continues today— financial conditions currently are as loose as when the fed funds rate was at just at 1.5%-1.75% in early-2018 and late-2019.