Former New York Fed President Dudley reiterated on Monday his statement from last Friday, believing there are sufficient reasons for the Fed to cut interest rates by 50 basis points at the September meeting. He also stated that he believes Fed Chairman Powell supports taking aggressive action, and a larger rate cut can bring the Fed's dot plot predictions closer to market expectations, while a 25-basis point cut is not supported by economic prospects and is an unpleasant surprise for the market.
Former Federal Reserve Vice Chairman and former President of the New York Federal Reserve, Dudley, said on Monday that the Federal Reserve faces a crucial decision at this week's meeting: whether to make a moderate cut of 25 basis points or to directly cut by 50 basis points to curb the economic recession in the United States.
Dudley reiterated the logic of a 50 basis point cut that he pointed out at the Bretton Woods Committee meeting in Singapore last Friday. "I believe there are sufficient reasons for a 50 basis point cut, regardless of whether they (the Federal Reserve) cut interest rates or not."
Dudley's latest statement indicates that he believes Federal Reserve Chairman Powell supports taking aggressive action. Powell specifically mentioned last month that further softening of the labor market is unwelcome, and now the employment market seems to be further declining. In addition, monetary policy is tight when it should be neutral or loose. A larger rate cut can bring the Federal Reserve's dot plot forecast closer to market expectations, while a 25 basis point rate cut is not supported by the economic outlook and is an unwelcome surprise to the market.
Dudley's column published in Bloomberg.
The Federal Reserve faces a key decision at this week's policy meeting: whether to slightly loosen monetary policy with a 25 basis point rate cut, or to rarely cut interest rates by 50 basis points to ward off an economic recession.
What should the Federal Reserve do? And what will they do? The answers to these two questions may not be the same. But this time, I believe the answers will be the same.
A series of news reports have fueled market expectations of a larger rate cut, significantly increasing the tension regarding the decision of whether to cut rates by 25 basis points or 50 basis points. As I pointed out at the Bretton Woods Committee meeting in Singapore last Friday, the logic supporting a 50 basis point cut is persuasive.
The dual goals of the Federal Reserve - price stability and maximum sustainable employment - have become more balanced, indicating that monetary policy should be neutral, neither restraining nor promoting economic activity. However, short-term interest rates are still far above the neutral rate, and this gap needs to be corrected as soon as possible.
Let's consider the economic data. The unemployment rate has risen by 0.8 percentage points from its low point in January 2023. In the past three months, the growth rate of nonfarm employment has been the slowest since 2020. Wage inflation has slowed to less than 4%, while the consumer price inflation index preferred by the Federal Reserve is around 2.5%. Despite a slightly higher-than-expected increase in core consumer prices in August, this was driven by categories that typically lag behind (such as insurance and housing), and the latest producer price report suggests that the core personal consumption expenditure index will be fairly moderate.
Some might even say that the downside risk to employment outweighs the upside risk to inflation. When the labor market deteriorates to a certain extent, this process tends to reinforce itself. Whenever the three-month average unemployment rate rises more than 0.5% from its low point in the previous 12 months, the end result is a larger increase in unemployment - at least 1.9 percentage points - and an economic recession. Given that the increase in the unemployment rate is mainly driven by rapid labor force growth, the threshold this time may be higher. But this does not negate the idea of the existence of a critical point and the notion that the labor market has either crossed or is approaching the critical point.
A 50 basis point rate cut also aligns very well with the latest economic forecasts that Federal Reserve officials will release this week. The market expects the Federal Reserve to cut interest rates by at least 100 basis points by the end of 2024. If the Federal Reserve were to cut rates by only 25 basis points now and indicate that it will cut rates by another 50 basis points at the next two meetings this year, it would send a hawkish signal. If the Federal Reserve were to cut rates by 25 basis points now and expect to cut rates by more than 50 basis points later this year, people would wonder why the Federal Reserve didn't cut rates immediately. Therefore, a larger rate cut would help the Federal Reserve get out of this complicated situation.
So why might the Federal Reserve not cut rates by 50 basis points? This is the best explanation I can think of.
First, the expected target for short-term interest rates is much more important than the speed of rate cuts. Expectations drive long-term interest rates, including mortgage rates. Considering the expectation of a total rate cut of about 250 basis points by the end of 2025, the rate cut this week should not have a significant impact.
Second, the Federal Reserve wants to ensure that it has already overcome inflation. The Federal Reserve has been fooled before: earlier this year, inflation rebounded, forcing the Federal Reserve to maintain high interest rates for a longer period of time. Federal Reserve Chairman Jerome Powell does not want to repeat the mistake of former Federal Reserve Chairman Arthur Burns, who did not persist in suppressing inflation in the 1970s.
Third, despite a slowdown in the U.S. economy and weakness in the labor market, there are hardly any signs that it is in or near a recession. The GDPNow model from the Atlanta Fed predicts an annualized growth rate of 2.5% for this quarter after adjusting for inflation.
Finally, a smaller interest rate cut may prevent Trump from complaining that the Federal Reserve is boosting the economy to improve Harris's election prospects. Federal Reserve officials probably prefer to stay as far away from this year's electoral politics as possible.
Nevertheless, I expect the Federal Reserve to adopt a policy of a 50 basis point rate cut. I believe Chairman Powell is inclined to take an aggressive approach: in his speech at the annual Jackson Hole global central bank meeting last month, he pointed out that the labor market is further weakening, which seems to be happening and would be "unwelcome." The monetary policy is tight when it should be neutral or even loose. By now taking a larger rate cut, the Federal Reserve is more likely to align its forecasts with market expectations rather than face unpleasant surprises that do not match the economic outlook.
Editor/Lambor