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The US Federal Reserve's recent decision to cut interest rates by 100 basis points, bringing the target range to 4.25%-4.5%, reflects a significant uncertainty regarding the future course of monetary policy. This uncertainty stems from a confluence of factors, primarily the unpredictable nature of inflation, the incoming Trump administration's economic agenda, and a debate within the Fed itself about the proximity of the neutral interest rate. The article's analogy of driving blindfolded with malfunctioning brakes aptly captures the precariousness of the situation. The Fed's projections, while indicating a slowing of inflation by 2025 and only two more rate cuts by December, are shrouded in considerable doubt, as evidenced by the majority of Fed board members and presidents expressing upward risks to their inflation forecasts and increased uncertainty regarding core Personal Consumption Expenditures (PCE) inflation.
A major source of uncertainty is the impending Trump administration. While Fed Chair Jerome Powell has cautiously avoided explicit political commentary, Trump's economic proposals present considerable ambiguity. The potential for sweeping tariffs, reminiscent of the trade war during Trump's first term, could exert upward pressure on prices. However, the historical precedent of the Fed cutting rates in response to the trade war's impact on financial conditions and business investment complicates the situation. Powell's attempt to downplay the impact of tariff-induced inflation using past research is undermined by the very different post-pandemic economic environment, where inflation expectations have been significantly altered. Further adding to the uncertainty are Trump's promises of extending and potentially expanding tax cuts, potentially boosting economic growth and inflation, especially if deficit-funded, and his immigration policies that could impact the labor supply, thus creating further economic ripples.
Compounding the uncertainty surrounding Trump's policies is the erratic behavior of US inflation data itself. Powell highlighted that recent inflation readings have been far from ideal, with the core PCE deflator rising by a concerning 0.3% in both September and October. While a cooling in November is anticipated, realized inflation is likely to surpass the Fed's earlier 2024 projections. Moreover, historical trends suggest that upside inflation surprises tend to concentrate in the first quarter of the year. This makes accurate forecasting extremely challenging. This instability in inflation data adds another layer to the overall uncertainty. The Fed's efforts to compensate for these fluctuations through seasonal adjustments appear insufficient to provide sufficient clarity on the inflation trajectory. This data-driven uncertainty adds weight to the concerns of policymakers and market participants alike.
Further complicating the picture is the ongoing debate within the Federal Reserve about the current status of interest rates relative to the neutral rate. Some Fed members argue that the economic landscape has fundamentally shifted in recent years, suggesting that current policy rates might be approaching or even near the neutral rate—a rate that is neither stimulative nor restrictive. However, opinions within the committee are divided. While Powell indicated that the Fed is getting close to neutral, he maintained that rates remain meaningfully restrictive. This ambiguity further underlines the difficulty in gauging the appropriate policy response. Contrasting views exist within the Fed, with some, like Cleveland Fed President Beth Hammack, voicing dissent against the latest rate cut and suggesting that current rates might already be close to neutral, and Fed Governor Michelle Bowman expressing a similar viewpoint that the Fed might be nearer to a neutral stance than currently believed. This divergence in opinion within the Fed itself highlights the lack of a clear consensus on the appropriate monetary policy strategy.
The overall conclusion of the article is that the Fed's optimal strategy at present appears to be a cautious approach, effectively hitting the pause button on further aggressive rate cuts. Powell's statement about being at or near a point where slowing the pace of adjustments is appropriate signifies a shift towards a more data-dependent and less proactive approach. However, this is not interpreted as a permanent halt to rate adjustments. A future scenario where Trump's economic policies lead to an economic slowdown is conceivable, which could trigger further rate cuts. Ultimately, the level of uncertainty remains exceptionally high. The future direction of interest rates hinges heavily on which campaign promises Trump keeps and the ensuing impact on the US economy. The article emphasizes that the extent of uncertainty is vast, and the Fed itself, just like the markets, is grappling with this considerable lack of clarity about the optimal course of action going forward.
Source: The US Fed seems as clueless as markets about its policy path from here on