The buttoned-down and boring-by-design world of American central banking was upended on Wednesday as the Federal Reserve cut its policy rate by 25 basis points amid a dissent by the Federal Reserve’s newest governor, Stephen Miran, who called for a 50 basis-point reduction.
There we no dissents from the hawkish members of the central bank who opposed a rate cut.
In addition, the stagflation implied by the Fed’s Summary of Economic Projections strongly suggests a tension inside the Fed that is now prepared to cut rates three times in the near term even as inflation increases.
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How the Fed balances its dual mandate of price stability and maximum sustainable employment will ultimately determine whether inflation becomes persistent and may also determine how much independence the Fed retains.
While the Fed’s interest rate forecast, known as the dot plot, sees two more rate cuts this year and one next year, its inflation forecast shows price increases remaining well above the Fed’s 2% target well into the future.
Based on the dot plot, five members of the Federal Open Market Committee see interest rates falling below 3% next year—a dovish outlook despite the upside risk to inflation.
We note here that of the four formal models that RSM uses to estimate the optimal policy rate, none imply rate cuts in the near term.
Given the coming changes to Federal Reserve personnel next year, we urge all to take this forecast with more than a grain of salt and would strongly suggest that the Federal Reserve is moving in a direction where it will tolerate inflation well above target.
It would not be surprising to see market players assume that the de-facto inflation target is moving higher, toward 3%.
The only way that inflation moves back to target in the medium term will be a recession, which is not the Fed’s core view nor that of RSM.
The forecast now rests upon just how entrenched the Fed’s credibility is and where public and professional inflation expectations will move over the next year.
Should prices rise above the Fed’s forecast, persistent inflation could be the outcome.
Summary of Economic Projections
The Fed is forecasting an era of stagflation-lite in which growth remains under 2% while inflation floats between 2.5% and 3% as unemployment moves to 4.5% this year, eases to 4.4% next year and 4.3% in 2027.
Growth is now expected to increase by 1.6% this year, 1.8% next year and 1.9% in 2027, which is essentially near the 1.8% long-run speed limit of the economy.
What is interesting is that the Fed sees little to no real improvement in the growth path despite its projection of a lower rate path and the onset of expansionary fiscal policies out of the fiscal authority.
Presumably, Miran, in calling for a bigger rate cut, submitted a much more robust growth path. One would expect this information in the upcoming Fed minutes to flesh out the board members’ differences in their views of the rate and growth paths.
The inflation forecast expects 3% in the personal consumption expenditures index this year, 2.6% next year and 2.1% in 2027 with a long-run rate of 2%.
The Fed’s core PCE estimate, which excludes the more volatile food and energy components, implies a 3.1% pace of inflation this year, 2.6% next year and 2.1% in 2027 while its forecast of the long-run rate remained unchanged at 2%.
The statement
The Fed’s policy statement included a downgrade of the description of the labor market by stating, “Job gains have slowed, and the unemployment rate has edged up but remains low,” while adding that “downside risks to employment have risen.” As for inflation, the statement said, “Inflation has moved up and remains somewhat elevated.”
Powell’s news conference
Federal Reserve Chairman Jerome Powell, perhaps sensing the internal inconsistencies within the Fed’s Summary of Economic Projections and its dot plot, highlighted the FOMC’s willingness to focus on price stability.
The first question for Powell on Wednesday was focused on the central bank’s independence in which Powell restated his intent to retain its instrumental independence but refused to elaborate.
Powell also said that the rate cut could be understood as a bit of risk management in which the Fed reduced its policy rate as a form of insurance as growth slows and hiring softens amid a curious balance to the labor market.
Powell noted that immigration policy is the primary cause of that curious balance and explicitly added that the unemployment rate could increase quickly should layoffs rise as growth in the labor supply remained constrained.
The takeaway
Tensions within the Fed’s dual mandate of price stability and maximum sustainable employment are at the heart of several inconsistencies inside the Fed’s rate, growth, inflation and unemployment forecasts.
Despite a forecast of rising inflation, the Fed is clearly preparing to reduce its policy rate by another 50 basis points this year, with one 25-point cut at its October meeting and another in December.
The central bank is forecasting a period of stagflation-lite ahead as the domestic economy adjusts to significant changes in trade and immigration policies that are affecting growth, employment and inflation.
