Federal Reserve Chair Jerome Powell recently testified that he’d like to see more good news on inflation before cutting interest rates. He got what he asked for.
Year-over-year headline inflation fell more than expected to 3% in June from 3.3% in May, and core inflation slowed to 3.3% from 3.4%. Investors promptly raised their bets that the Fed would cut its policy rate in September — and began to wonder if it might happen as soon as the end of this month.
There’s no reason to rule out either date. Given the risk of a slowing economy, a modest easing now looks right. Although inflation remains elevated, the latest data suggest that a slightly lower policy rate should still be restrictive enough to hit the Fed’s 2% target. Growth in output was 2.8% annualized in the second quarter — a little more than expected, but confirmation even so that the economy has cooled a lot since last year. An associated measure of underlying inflation also moved down to less than 3%. At the central bank’s policy meeting this week, it would be fair to conclude that short-term interest rates can be trimmed.
However, a different question matters more than whether the Fed cuts now or two months from now — namely, what Powell and his colleagues say about their intentions after that. If they’re wise, they’ll leave their options open.
The Fed has rightly promised to follow the data. Yet financial markets are awaiting not one cut, but a “pivot” to a path of lower rates. This perception is unhelpful. It assigns the next move, however modest or tentative, too much importance, and it could tie the Fed’s hands should conditions change.
Admittedly, the market’s expectation is logical. It arises from the central bank’s desire to adjust policy gradually and predictably, avoiding surprises. Stability is good — but gradualism and data dependence sometimes pull in different directions. When the facts change, central bank officials need to be free to change their minds. If they tie policy to some real or imagined schedule, the surprises, though delayed, tend to be bigger and nastier.
The current policy rate of 5.25% to 5.5% is firmly pressing down on demand. Housing inflation, notably stubborn up to this point, has subsided; services prices excluding housing and energy, a closely watched indicator, fell in June for the second month running. Crucially, the previously overheated labor market has cooled. Job openings are sharply lower and the unemployment rate has increased to 4.1%. The balance of risks has shifted and the case for a rate cut looks sound.
Here’s the crucial point: If the Fed does cut, it should explain the change as sufficient given the data, not as the prelude to more easing. If subsequent data suggest inflation is stabilizing above 2%, the easing will need to be reversed, and the Fed should alert investors to that possibility. Moreover, the idea of a path leading back to a normal policy rate assumes the central bank knows what this “normal” number is. It doesn’t, nor does anybody else. In due course, the data will say. Until then, one step at a time.
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