As expected, the Fed cut rates by 25 basis points, to below 4 percent for the first time in three years. But divisions within the central bank (one vote for a bigger cut, and one for no cut at all) and more hawkish comments than expected from Fed Chairman Powell only reinforced the case (at least for me) that there should not have been a cut. To be sure, there are some signs of a weakening labor market — the core of the argument for a cut — but there’s nothing to suggest that 2 percent inflation, the Fed’s supposed target, is anywhere in sight.
That the government shutdown has hit the flow of official data only complicates matters further. Even if the Fed is not exactly flying blind, its vision is impaired, an argument for caution. And how cautious was any cut? On the other hand, expectations for another cut before the year’s end have fallen after Powell warned that it was not a “foregone conclusion.” Powell also said that the current rate was closing in on a neutral level, a suggestion that he may want to stick with the new status quo for more than a month or two.
Last week, Bloomberg’s Jonathan Levin looked into the most recent inflation data and found little — to put it mildly — to reassure those who feel that inflation is headed toward 2 percent:
On a month-on-month basis, the core Consumer Price Index — which excludes food and energy — was up just 0.2% in September, less than the 0.3% expected by economists in a Bloomberg survey. But on a three-month annualized basis, it is still running at around 3.6%, hotter than the 3% increase over the previous year.
Trump’s tariffs are biting, if by less than expected, but it’s far too soon to assume that the worst of their effect on price levels (and thus, critically, expectations of future price levels) has passed. Meanwhile, in the core services segment (which excludes housing) prices were up 3.2 percent, and those, by definition, are affected only indirectly by import taxes, so what to make of that?
Also writing in Bloomberg, Clive Crook — in a piece published before the Fed announced its decision — raised the question of whether investors are beginning to think of 3 percent as the new normal.:
Core PCE inflation (the central bank’s preferred measure) fell to 3.1% at the end of 2023. Two years later, it’s still roughly 3%. Private forecasters surveyed by Bloomberg expect it to be only a little less than 3% a year from now. Forecasts of unemployment have edged higher but are still consistent with “full employment.” And forecasts of output in the current year are higher than before. Given all this, the Fed is cutting rates? You’d be forgiven for assuming that its inflation target is 3%, not 2%.
Working backward from other benchmarks, you’d conclude much the same. For instance, the Fed says the long-term real interest rate is 1%. With inflation at 3%, that suggests a neutral policy rate of 4%, which is about where it stands. On the face of it, merely leaving the rate alone would indulge inflation at 3%; cutting it hardly signals commitment to the 2% target. In the same way, Taylor-rule calculations based on an inflation target of 2% call for a policy rate of a little over 4% (depending on assumptions). At the moment, most Taylor-type formulas would justify an increase in the policy rate more readily than a cut.
And yet a cut is what we saw, albeit with the reservations referred to above. Sooner or later, that cut — let alone any successors — is likely to reinforce market suspicions that not only is the Fed listening to the White House more attentively than it should, but also that 3 percent inflation is, however discreetly, to be the new normal. And if that occurs, 3 percent will not be the new normal for very long.