The Federal Open Market Committee delivered a third consecutive 25 basis-point rate cut at its meeting on Wednesday, bringing the federal funds rate to a range between 3.5% and 3.75%. In addition, the Federal Reserve reduced interest in excess reserves to 3.65% and the discount rate to 3.75%.
But the tone and tenor of the FOMC’s statement and remarks by Chairman Jerome Powell afterward substantially raised the bar for a rate cut in January.
What’s more, the cumulative data included in the Summary of Economic Projections strongly implies that there is not a consensus on moving the policy rate down to 3%, which is the Fed’s estimate of the terminal rate.
The strong upgrade to the growth outlook next year and a near-full unemployment rate begs the question: Why was the rate cut needed at all?
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In addition, the FOMC changed the language in its statement that suggests a lack of conviction on the need for any cuts in the near term, saying, “in considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.”
Powell, in his remarks afterward, stated that the policy rate is now within a broad range of neutral: “We are in a position to see how the economy evolves, which should be interpreted as policy is not currently restrictive and additional cuts would require a deceleration in growth below the long run 1.8% potential.”
That remark implies confidence in getting inflation back to the Fed’s 2% target without maintaining restrictive monetary policy. Yet the Summary of Economic Projections does not expect a return to the 2% target until 2028, so it does not take much to see the weak spots in policy.
The median projection on the policy rate as seen in the dot plot forecast is one more 25 basis point cut next year, which is quite interesting given the three dissents within the FOMC.
As expected, Governor Stephen Miran dissented in favor of a 50 basis-point cut. amd two regional Fed presidents, Jeffrey Schmid of Kansas City and Austan Goolsbee of Chicago, dissented in favor of no rate cut.
The median policymaker expects an inflation rate of 2.4% by the end of next year, which is down from 2.6% in September, with GDP growth rising to 2.3% from 1.8% previously.
The Fed does not expect inflation to return to the 2% target until 2028, which implies a full seven years between the Fed falling behind the curve on inflation and reaching its target.
Summary of Economic Projections
The Fed kept its long-run projection of economic growth of 1.8% but now has a much more constructive view of growth, projecting a rate of 2.3% next year, 2% in 2027 and 1.9% in 2028.
Its estimate of full employment now stands at 4.2%, but the Fed now expects unemployment to peak this year at 4.5%, decline to 4.4% next year and fall to 4.2% thereafter.
It is important to note that the retirement of baby boomers and tight immigration policies are part of the reason for the reduction in the estimation of full employment and expectations of what are historically low unemployment rates.
Inflation in the personal consumption expenditures index, the Fed’s preferred gauge of inflation, is expected to peak at 2.9% this year and ease to 2.4% next while core PCE, which is the better long-term predictor of overall inflation, is expected to peak at 3% this year and 2.5% in 2026.
The K-shaped economy
The United States has a bi-furcated, or K-shaped, economy in which it is impossible to make policy that reconciles the needs of those with higher incomes who live on the upper spur of K and those with lower incomes on the lower spur.
The Fed forecast of the terminal rate for the overall economy is almost certainly not appropriate for the lower spur of the K and is almost certainly too accommodative for those in the upper spur.
The Fed’s estimate of the terminal rate of 3% is 50 basis points lower than the RSM estimate of 3.5%.
In our estimation, a rate cut based on the upgrade to GDP growth this year and next makes one ask why a rate cut was needed at all given the start of expansionary fiscal policies next year that will inject significant amounts of cash into the economy.
In addition, all of the four models that we run to estimate the optimal policy rate strongly imply that a rate cut is not appropriate at this time.
One does not have to be a capital markets professional to understand that the primary impact of a rate cut will be an increase in leverage through easier financial conditions among those in the upper spur.
If anything, an estimate of the terminal rate for the upper spur of the K suggests that a rate increase might be in order.
While people in the lower spur of the K will benefit from lower interest rates, there is no guarantee that long-term interest rates will not increase under current economic conditions.
Expansionary fiscal policies, after all, will push growth to 2.3% next year, the Fed estimates, as competition for scarce capital intensifies in both the public and private sectors.
The takeaway
The Fed cut its policy rate by 25 basis points to a range between 3.5% and 3.75%. But the dot plot strongly implies there is not a consensus to reduce the policy rate more than one time next year.
Just as important, the Fed lifted its expectations of growth next year which, along with the increase in cash to American households via changing tax policy, will create doubt about the path of monetary policy. This dynamic in our estimation substantially lifts the bar on any prospective rate cut at the Fed’s next meeting in January.
