Fed Officials Continue to Diverge on Where Funds Rate Should Go in Future

(MaceNews) - Federal Reserve officials have expressed general support for lower interest rates this week but have diverged on how much further monetary easing might be warranted.

Some officials have made clear they want additional cuts in the key federal funds rate after the Fed’s rate-setting Federal Open Market Committee voted 11-1 last Wednesday to cut its policy rate by 25 basis points to a target range of 4.0% to 4.25% after leaving its overnight policy rate unchanged for nine months following 100 basis points of rate cuts over the last three meetings of 2024.

Others are more hesitant to continue easing.

Not surprisingly, the biggest advocate of additional rate cuts has been Stephen Miran, President Trump’s nominee to fill a board vacancy, who was confirmed by the Senate on the eve of the FOMC meeting. Miran, who dissented in favor of a 50 basis point cut, argued Monday that the funds rate remains ”roughly two percentage points too tight.”

Governor Michelle Bowman sounded somewhat less dovish Tuesday morning, but she too contended the FOMC should continue to “proactively remove some policy restraint” to guard against labor market “deterioration.”

Miran and Bowman deemphasized inflation risks in favor of “downside risks” to employment.

But others were less eager to cut rates further.

St. Louis Federal Reserve Bank President Alberto Musalem voted for the 25 basis point cut, but looking ahead on Monday, he foresaw only “limited room for easing further without policy becoming overly accommodative.”

Likewise, Cleveland Fed President Beth Hammack, who also voted for last Wednesday rate reduction, said the FOMC “should be very cautious in removing monetary policy restriction” in order to get inflation down from nearly 3%.

Non-voting Atlanta Fed President Raphael Bostic is holding to his view that only one 25 basis point rate cut was needed.

Meanwhile, Chair Jerome Powell trod a cautious middle ground, reiterating that the FOMC faces “a challenging situation” of risks on both sides of its dual mandate. His implication was that he and his colleagues faced difficult policy choices in coming months.

“Two-sided risks mean that there is no risk-free path,” he said in remarks prepared for delivery to the Greater Providence (R.I.) Chamber of Commerce.

“If we ease too aggressively, we could leave the inflation job unfinished and need to reverse course later to fully restore 2% inflation,” he continued. “If we maintain restrictive policy too long, the labor market could soften unnecessarily. When our goals are in tension like this, our framework calls for us to balance both sides of our dual mandate.”

Powell said “the increased downside risks to employment have shifted the balance of risks to achieving our goals,” making it “appropriate at our last meeting to take another step toward a more neutral policy stance….”

Last Wednesday’s rate cut left the federal funds rate “still modestly restrictive” and left the FOMC “well positioned to respond to potential economic developments.” But he reiterated that “our policy is not on a preset course,” and the FOMC will have to “determine the appropriate stance based on the incoming data, the evolving outlook, and the balance of risks.”

The FOMC gave strong indications that more rate cuts are coming in its policy statement last Wednesday, saying, “downside risks to employment have risen” – a point Powell made repeatedly in his post-FOMC press conference. New language in the statement also implied more easing by stating: “In considering 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.”

Moreover, the FOMC’s new quarterly Summary of Economic Projections anticipated the funds rate will fall another 50 basis points before the end of 2025 and go lower yet over the next two years. The 19 FOMC participants projected the funds rate will fall to a median 3.6%, implying two 25 basis point rate cuts at the Oct. 28-29 and Dec. 9-10 meetings to a target range of 3.5-3.75% (25 basis points less than in the June SEP).

The funds rate was projected to fall further to a median 3.4% (3.25-3.50%) by the end of 2026, and to 3.1% (3.0-3.25%) by the end of 2027. That would leave the funds rate just a tenth over the estimated “longer run” or “neutral” funds rate.

But the median projections mask what Powell called “a wide dispersion of views.” While nine of the 19 officials projected the funds rate will fall an additional 50 basis points to 3.6% by the end of this year, seven projected it will stay above 4%.

Those divergences have been reflected in officials’ comments over the last two days.

Miran maintained “monetary policy is well into restrictive territory.”

“Leaving short-term interest rates roughly two percentage points too tight risks unnecessary layoffs and higher unemployment,” he told the Economic Club of New York.

Miran strongly implied he will push for a 50 basis point rate cut again at the October FOMC meeting. “I arrive at a view, and then I will sort of continue, you know, until my view changes, I will continue arguing for that view. And if that means continuing dissent, that means continuing to dissent.”

Bowman was nearly as vociferous in favoring further easing Tuesday morning.

“So far this year, even with inflation within range of our target, the Committee has focused primarily on the inflation side of the dual mandate,” she told the Kentucky Bankers Association. “Now that we have seen many months of deteriorating labor market conditions, it is time for the Committee to act decisively and proactively to address decreasing labor market dynamism and emerging signs of fragility.”

Warning that “we are at serious risk of already being behind the curve in addressing deteriorating labor market conditions,” Bowman said, “Should these conditions continue, I am concerned that we will need to adjust policy at a faster pace and to a larger degree going forward.”

“Because our dual mandate places equal weights on the two goals, we should turn our focus toward the side of the mandate that is showing signs of deterioration or fragility even though inflation is above but within range of our target.,” she continued. “This should be especially the case since forecasters widely expect inflation to significantly decline next year, and as further deterioration in labor market conditions would likely lead to more persistent damage to the employment side of the mandate that would be difficult to address with our tools.”

Pointing to “significant progress” in reducing inflation to “within range of our target.” Bowman said, “economic research is clear that, when conditions exist like those we are currently facing, monetary policy should de-emphasize inflation.”

“The U.S. economy is experiencing aspects of a negative supply shock from higher tariffs that is also affecting aggregate demand,” she went on. “Since these conditions are unlikely to lead to persistent effects on inflation, and because changes in monetary policy take time to work their way through the economy, optimal policy calls for looking through temporarily elevated inflation readings.”

“Therefore, we should proactively remove some policy restraint on aggregate demand to avoid damage to the labor market and a further weakening in the economy, provided that long-run inflation expectations remain well anchored,” Bowman added.

“In terms of risks to achieving our dual mandate, as I gain even greater confidence that tariffs will not present a persistent shock to inflation, I see that upside risks to price stability have diminished,” she elaborated. “With softness in aggregate demand, and signs of fragility in the labor market, I think that we should focus on risks to our employment mandate and preemptively stabilize and support labor market conditions.”

Bowman expressed concern that “the labor market could enter into a precarious phase and there is a risk that a shock could tip it into a sudden and significant deterioration.”

She said the FOMC needs to signal “an appropriate forward-looking view of additional policy adjustments...because it shapes the expected path of short-term interest rates, which, in turn, affects longer-term interest rates, including mortgage and corporate bond rates, that are key for household and business decision making.”

“Cutting the policy rate 25 basis points and signaling additional adjustments at upcoming meetings should allow longer-term interest rates to remain materially lower than earlier this year and help to support the economy,” Bowman concluded.

But a very different perspective came from Musalem who said he voted for an initial rate cut as “a precautionary move intended to support the labor market at full employment and against further weakening,” but suggested that was enough for the foreseeable future.

With the funds rate now 25 basis points lower, “the stance of monetary policy now lies between modestly restrictive and neutral, which I view as appropriate,” he said in remarks at the Brookings Institution.

Musalem said “there is limited room for easing further without policy becoming overly

accommodative, and we should tread cautiously…” For one thing, he said financial conditions “are already supportive of economic activity.” What’s more, “looking through direct one-time effects of tariffs…. could risk price stability if taken too far, or if maintained for too long.”

Musalem didn’t rule out supporting further rate cuts “provided the risk of

above-target inflation persistence has not increased and longer-term inflation expectations

remain anchored.”

However, he went on, “Overemphasizing the labor market objective runs a risk of excessive policy easing, which could cause a further steepening of the yield curve, a rise in the term premium or an increase in inflation expectations. Any of those effects could do more harm than good to the labor market and contribute to more persistent above-target inflation.”

“However, if inflation expectations are well anchored, overemphasizing the inflation objective

runs the risk of not providing enough support to maintain a full-employment labor market at a

time when downside risks have risen. Again, balance is the key,” Musalem added.

Hammack made clear she too is reluctant to take easing much further at this juncture at a Cleveland Fed event.

She said August’s 4.3% unemployment rate is “right around a maximum employment number," while “on the inflation side, we are missing by a more meaningful number, by a full percentage point. And we have been missing for four-and-a-half years, and I anticipate missing for the next couple of years."

So Hammack advised “we should be very cautious in removing monetary policy restriction because I think it's important that we stay restrictive to bring inflation back down to target."

Non-voter Bostic was also reluctant to support further rate cuts Monday, revealing that he held to his long-standing belief that only one 25 basis point rate cut was needed when writing down his funds rate “dots” for the revised SEP.

"I think there's a debate about the balance of risks, and I will acknowledge that the risks have shifted," Bostic said. "But for me, the risk to the price-stability mandate is still the most significant.”

“We are not at target. We're still a ways from it. We get signs from our contacts and from our surveys that prices are likely to still go up some more from here. So we're going to see upward movement in inflation. I worry about that," he added in comments released by the Atlanta Fed Monday

Bostic downplayed employment risks in an interview with the Wall Street Journal. "There may be some weakening, but no one is expecting dramatic changes on the employment side. I don't think the labor market is in crisis right now. I think that there is a fair amount of uncertainty, and businesses have been telling us basically one thing for the whole year, which is they're not hiring and they're not firing and they're waiting to see how things shake out on the policy side—because that'll determine how businesses are engaged with their customers and what customers are going to be wanting to buy and willing to buy."

Some of the disagreement about the appropriate federal funds rate level is traceable to different views on where funds rate neutrality is, which in turn centers on the esoteric concept of the real equilibrium short-term interest rate or r*.

When it comes to estimating the “longer run” (or “neutral”) funds rate for the SEP, FOMC participants readily agree on the inflation component; it’s the Fed’s stated 2% inflation target. But estimates of the real component (r*) vary widely.

In recent years, as the economy recovered from the Covid-driven shutdown of the economy, Fed officials have, to varying degrees, argued that the real rate has risen, resulting in an increase in estimates of the the longer run neutral funds rate from 2.5% at the end of 2023 (and even lower in previous years) to 3.0% in the latest SEP. .

Although the median “longer run” funds rate was left at 3.0%, estimates ranged from as low as 2.8% to as high as 3.6% -- the range reflecting differences over r*.

Though r* and in turn the neutral funds rate is a hypothetical construct, it matters to monetary policy thinking because a higher real rate implies a higher neutral rate and, in turn, a higher nominal funds rate to achieve the Fed’s dual mandate objectives. To the extent that the real rate is believed to have risen, the perceived level of funds rate neutrality has also risen, implying that the FOMC needs to cut the actual funds rate less. Conversely, if the real rate and in turn the neutral rate is believed to be lower, that implies the need for more rate cutting.

Miran devoted much of his first speech as a Fed governor to an elaborate analysis of the factors which he thinks has lowered the neutral rate.

“It is my view that previously high immigration rates and large fiscally driven decreases in net national saving, both of which raise neutral rates, were insufficiently accounted for in previous estimates of neutral rates,” he said. “Monetary policy was not as tight as many believed.”

“That same effect may be taking place today, but in the opposite direction,” Miran continued. “In my view, insufficiently accounting for the strong downward pressure on the neutral rate resulting from changes in border and fiscal policies is leading some to believe policy is less restrictive than it actually is.”

Plugging a lower r* into a standard Taylor Rule model, he said “the fed funds rate should be around 2 to 2.25 percent.”

“The upshot is that monetary policy is well into restrictive territory. Leaving short-term interest rates roughly 2 percentage points too tight risks unnecessary layoffs and higher unemployment,” Miran declared.

Others make opposite arguments. The mere fact that the economy has continued to perform fairly well near “full employment” proves that the funds rate is not far above neutral, some say.

Musalem said “the ex ante real policy rate is already close to neutral. The nominal policy rate is now

4.1%. Markets expect an inflation rate of 3.3% over the next 12 months. So, the ex ante real policy rate is 0.8%. This is below the 1% median long-run real neutral rate of FOMC participants.”

“I do not view 1% as a floor below which the real policy rate must not go,” he continued. “But to go there, I believe the outlook or balance of risks must shift further from where they are today, especially if inflation looks likely to remain persistently above target.”

Likewise, Hammack said “we are only a short distance to neutral, and it worries me that if we remove that restriction from the economy, things can start overheating again.” She said she has “one of the higher estimates (of neutral) on the committee, and I think we're only very mildly restrictive after last week's move. So, I think we are a very short distance to neutral."