In normal times, the conduct of monetary policy is like driving a car through a fog of uncertainty. You have a general idea of where you’re going, but must move slowly to avoid accidents. At the moment, it’s more like driving while double blindfolded—in a car with malfunctioning breaks. The most prudent move is to stop.
With this week’s decision, the US Federal Reserve has now cut rates by 100 basis points to 4.25%-4.5%, appropriate adjustments given the moderation in inflation from its peaks of 2022. But nobody knows what comes next—and I mean nobody. The key feature of the Fed’s latest economic projections was the uncertainty around them.
The median forecaster on the Fed’s rate-setting panel projects that inflation progress will slow meaningfully in 2025, and that the central bank will cut rates just two more times by next December.
But among the 19 Fed board members and Federal Reserve Bank presidents, 15 now say that the risks to their forecasts for core personal consumption expenditures inflation data are weighted to the upside, the most since 2022; 14 said that their uncertainty about core PCE, the Fed’s favoured inflation gauge, had increased since they last filled out the survey in September.
Why is everyone so uncertain all of a sudden? First, there’s President-elect Donald Trump. Though Fed Chair Jerome Powell has been careful about opining on politics, Trump’s agenda introduces a raft of two-sided risks. His threat to impose sweeping tariffs on US trade partners could mechanically increase price levels.
Yet, if we look to Trump’s first presidency, the trade war he unleashed prompted the Fed to cut rates in response to an upheaval in financial conditions and the prospect of reduced business investment.
Powell brought to Wednesday’s press conference details from 2018 Fed research that suggested looking past tariff-induced inflation. Yet, this environment is clearly different from what existed pre-pandemic in a variety of ways, with inflation expectations shaken by the past four years.
Trump has also promised to extend tax cuts enacted in 2017 and maybe add new ones, which could have the effect of further juicing economic growth and inflation—especially if they are deficit-funded. And he’s threatened mass deportations of undocumented immigrants that could cut into the labour supply.
Second, there’s the wobbly nature of US inflation data itself—a risk that Powell played up. Asked if the uncertainty among officials was all about Trump, he reminded reporters that the latest inflation readings had been far from pristine. The core personal consumption expenditures deflator rose by a too-high 0.3% in each of September and October.
Though the pace is likely to have cooled in November, the upshot is that realized inflation will almost certainly exceed the Fed’s earlier 2024 projections. And recent experience suggests that upside inflation surprises tend to be concentrated in the first quarter, despite attempts to compensate for such trends through seasonal adjustment.
Overall, I suspect that Powell emphasized these bumps and wiggles in the data partially to avoid too many Trump questions, but he’s right that the data has been frustrating.
Third, there’s uncertainty about how the interest rate backdrop is actually affecting the economy. Some members of the Fed’s rate-setting committee have argued that the world has fundamentally changed in recent years, and that policy rates as they stand today may actually be close to the ‘neutral’ rate—the setting that’s neither stimulative nor restrictive, but just right.
As Powell said Wednesday, “We are significantly closer to neutral,” but also “still meaningfully restrictive”—whatever that word salad means.
Others think we may already be pulling into the neutral station. Federal Reserve Bank of Cleveland President Beth Hammack, who registered the lone dissent against Wednesday’s rate cut, said this month that “we may not be too far from a neutral setting today.” And Fed Governor Michelle Bowman said in November that “we may be closer to a neutral policy stance than we currently think.”
The upshot of all of this is that the Fed’s best option is to put the car in park, and it has left the door open to doing just that. In his remarks Wednesday, Powell said that the central bank is “at or near a point at which it will be appropriate to slow the pace of further adjustments.” I don’t think that all of this necessarily means that rates will be suspended here indefinitely.
There’s a scenario in which the Trump agenda could ultimately precipitate an economic slowdown and rate cuts. It all depends on which campaign promises he keeps. All we know is that we don’t know enough, and Powell himself is as clueless as many in markets. ©Bloomberg
