The interest rate decision announced by the Federal Open Market Committee (FOMC) contained the expected quarter-point reduction in the Federal Funds target range to 3.75%-4.0%. Several less expected and highly significant developments were highlighted in the full text of the announcement, however. First, the FOMC stated that it would end on December 1 its longstanding Quantitative Tightening (“QT”) effort of reducing the Federal Reserve balance sheet, thereby further easing monetary policy constraints on economic growth. At the inception of quantitative tightening 3.5 years ago, there were numerous estimates that the Fed’s balance sheet sales were roughly the equivalent of a quarter-point increase in interest rates. Thus, the cessation of QT is the elimination of one pillar of the Fed’s “modestly restrictive” stance. The second interesting part of the announcement was the mention of two dissenters from the target rate reduction decision: Stephen Miran, who, not surprisingly, voted for a more aggressive half-point reduction, but was now joined by Jeffrey Schmid, President of the influential Kansas City Fed, voting against any reduction whatsoever. From an economic viewpoint, it is easier to understand Schmid’s dissent than Miran’s; the FOMC announcement cited moderate US growth, still-low unemployment, and inflation that moved up and remained “somewhat elevated”, without making much of a case for the claim that “downside risks to employment rose in recent months.”
The surprise of the press conference was the emphasis given to “strongly different views” in the FOMC, beyond just Miran and Schmid. And whereas it was initially thought that those differences of opinion pertained to the current target rate cut, it was eventually made apparent that the differences of opinion involved the December meeting. It is highly unusual for Chairman Powell to acknowledge that there has been any discussion of future rate cuts, let alone to mention that there is already substantial dissension over future actions. An attempt to characterize the differences of opinion as being related to data issues associated with the government shutdown was only partially successful; ultimately, there was mention of something probably much closer to the truth — different views on the neutral rate of interest. The neutral rate of interest is, of course, not directly or theoretically observable, as Chairman Powell has pointed out numerous times. By listing the neutral rate of interest as a factor in the intense FOMC discussion at this meeting, Chairman Powell seemed to be calling attention to a very plausible discussion regarding economic growth, employment, and inflation. Given that 1)the economy is viewed by the Federal Reserve as currently posting moderate economic growth and 2) the labor market has softened somewhat, but not precipitously and 3) inflation due to tariffs is most likely temporary, with the underlying trend still heading towards 2% over the longer term . . . might not this latest Federal Reserve rate cut represent the actual neutral rate of interest? If so, why cut further?
The answer, of course, continues to be one of risk management. Specifically, the assessment is that the risk of the labor market becoming rapidly weaker is greater than the risk of inflation rising to sustained, uncomfortable levels. One question from the press conference framed the issue in a similar but much more pointed manner: What is the risk of a Fed mistake? Many might answer that as “high”, especially with the proper consideration given to Chairman Powell’s expressed view that the dominant source of the employment slowdown is the “massive decline” in the supply of labor (due to the drop in immigration), not the weakening of labor demand (though that is in play as well, purportedly due to AI). If Federal Reserve monetary policy cannot impact the actual sources of the employment slowdown, perhaps the Fed would be better off focusing on inflation, which may not be transitory. No wonder there is rising debate and emerging dissent.
Investors who embraced the certainty of a rate cut in December, followed by at least another three— totaling a full 100 bps down from where the target rate currently sits — are deeply unsettled. They should be. As Chairman Powell said in his opening remarks, the economic outlook is uncertain. So, apparently, is the near-term outlook for monetary policy.