Due to uncertainties such as facing Republican control, rising productivity, and slowly improving inflation, several Federal Reserve officials have expressed their willingness to lower interest rates more cautiously next year.
The minutes from the Federal Open Market Committee (FOMC) meeting on November 6-7 will be released at 3 AM the following day, which may provide more clues about whether policymakers are reconsidering the pace and extent of rate cuts.
Federal Reserve Chair Powell, Governor Bowman, and Dallas Fed President Logan have suggested that they are not in a hurry to cut rates, although no one ruled out the possibility of a rate cut at the Fed's next meeting in December.
Kathy Bostjancic, Chief Economist at Nationwide, stated, "They want to ensure they have options because economic growth is more resilient and inflation shows more stickiness."
Federal Reserve officials lowered interest rates in November, but investors have already reduced their bets on another rate cut next month. Market pricing indicates that the chances of a 25 basis point rate cut by the Fed in December are just slightly above 50%, down from about 80% before the November meeting.
The latest minutes may clarify three key issues that have emerged in policymakers' recent public statements:
Neutral interest rate or higher
Some Federal Reserve officials have indicated that their current goal is to gradually lower the policy interest rate over time to a level that neither suppresses nor stimulates the economy. However, given the unexpectedly strong economic performance over the past two years, many of them seem to be reassessing what the so-called neutral interest rate is.
Bowman stated on November 20, "My estimate of the neutral policy rate is much higher than before the pandemic," and if the Fed continues to cut rates, "the policy rate may reach or even fall below neutral before we achieve our price stability target."
If borrowing costs fall below neutral, policymakers will face the risk of excessively stimulating the economy and spurring price increases.
Logan stated on November 13, "I see a lot of signs that the neutral rate has risen in recent years, and some signs suggest that the neutral rate may be very close to the current federal funds rate."
A 25 basis point rate cut next month would bring the federal funds rate down to a range of 4.25% to 4.5%. This would be a full percentage point cut since last September, marking the fastest rate cuts by the Fed since 2001, excluding crises. It would also leave borrowing costs only about 75 basis points above the neutral rate metric preferred by investors.
Federal Reserve officials are required to submit their own estimates of the neutral interest rate (also known as the "long-term" federal funds rate) each quarter. These predictions have been steadily rising, with the median forecast in September at 2.9%, up from 2.5% in December 2023. However, there are significant divisions among policymakers in the latest predictions: 12 officials expect the neutral rate range to be 2.375% to 3%, while 7 officials expect it to be 3.25% to 3.75%.
Both the economy and the markets seem to agree that the neutral interest rate is already higher. While most Federal Reserve officials insist that policies are restrictive, overall demand remains healthy, and inflation is not convincingly stable near the 2% target level.
Surge in productivity
After years of tepid growth, the rebound in U.S. labor productivity is another surprise.
Hourly output in the U.S. has surpassed pre-pandemic levels
As a key factor in improving living standards, the acceleration of hourly output is always welcomed by Federal Reserve officials. This is a sign that labor is becoming more efficient with the help of more advanced technologies. However, this also poses challenges for monetary policy.
A more efficient economy can achieve faster growth without triggering inflation. Meanwhile, sustaining that growth typically requires more capital investment.
Jason Thomas, global head of research and investment strategy at Carlyle Group Inc., stated that the increase in productivity, along with tax-cut policies that the incoming Trump administration may push for growth, raises the risk of the Fed cutting rates too much and too quickly.
He said, "In terms of risk and reward, I can't imagine they would be willing to cut rates to that extent. When demand for capital and labor increases, if rates are too low, there is a risk of overstimulation, which leads to inflation."
Clearly, the Fed is trying to avoid this risk. Powell stated on November 14, "The economy has not signaled that we need to rush to cut rates."
Thomas expects the Fed to have one or two more rate cuts, possibly in March and June of next year.
Uncertain inflation outlook
Federal Reserve officials believe they are achieving price stability, but have not yet reached the target, and the proposal from elected President Trump brings significant uncertainty. Deregulation and tax cuts could boost growth and stimulate inflation, while tariffs and expelling illegal immigrants could suppress consumption, investment, and growth, while also raising prices. No one really knows how these policy combinations will play out.
The Fed's preferred inflation indicator has proven sticky
Former Cleveland Fed President Mester stated that the conclusion drawn from the post-2021 inflation surge is that policies need to be prepared to address a range of risks during highly uncertain times, which may mean gradual interest rate cuts.
"What you want to do is ensure that policy is in a favorable position so that you can address risks in any way," said Mester, who is now a part-time finance professor at the University of Pennsylvania's Wharton School. "In a strong economy, there is no reason to rush," she said.
Article forwarded from: Jin Shi Data