Which Path Will the Fed Take to Ease Monetary Policy?

At the press conference following the meeting, Fed Chair Jerome Powell indicated the action reflected growing confidence that the Fed's 2 percent inflation target was within sight. At the same time, the labor market has cooled in the last three months. As a result, the balance between the risk of inflation and unemployment had shifted in favor of ensuring that the job market would not deteriorate materially.

Future Rate Cuts

The main unknown now is what the future path of easing will look like. According to John Authers of Bloomberg, some of the steam from the 50 basis point rate cut dissipated when Powell doused expectations for additional large cuts to follow. He indicated that people should not assume that this is the pace of what future rate cuts might be, considering that the economy is in good shape.

The median projections now call for the Fed funds rate to decline to about 3.25-3.5 percent by the end of next year, which is close to the 3 percent rate the bond market was pricing in. If so, it would be the first time the Fed did not cut rates aggressively, as it did after the bursting of tech and housing bubbles and the COVID-19 pandemic.

The primary reasons the Fed is unlikely to move as quickly this time are that recession does not seem imminent and signs of strain in financial markets and the banking system are scant.

Beyond that, there is little historical experience to guide policymakers or investors, because the current economic cycle is like no other in U.S. history. As economists at the Richmond Federal Reserve observe, this cycle is the first over the entire postwar period where there has been significant progress in lowering inflation without an associated increase in the unemployment rate.

Labor Market & Investor Concerns

However, financial market volatility has heightened considerably during the past two months mainly in response to data showing slowing job growth. Thus, while nonfarm businesses created 142,000 jobs in August, estimates for the two previous months were revised down by a net 86,000.

This has added to investor angst that the economy could be weakening. However, Fed officials anticipate only a modest increase in the unemployment rate, with its median forecast for this year and next at 4.4 percent, up from 4.2 percent currently.

Although Fed officials have emphasized their decisions will be data-dependent, investors perceive that this means they will be "behind the curve" in responding to recession risks. For example, the latest Bank of America survey of global fund managers showed that respondents believe global monetary policy is the most restrictive at any time since the 2008 financial crisis. Yet, the vast majority of respondents also believe a U.S. "soft landing" is the most likely outcome.

The justification for Fed rate cuts in this situation is that with inflation approaching the Fed's 2 percent target, monetary policy should be neutral rather than restrictive.

My take is that if there is a soft landing, real interest rates should be around 1-1.5 percent versus about 3 percent before the Fed eased. Assuming that inflation approaches 2 percent over time, this would imply a terminal Fed funds rate in the vicinity of 3-3.5 percent.

Role of Fiscal Policy

One lesson from the post-pandemic economy is that the Federal Reserve also needs to account for the role that fiscal policy may play. During the pandemic, massive federal programs totaling $4.6 trillion were enacted to support households as businesses were shuttered, but they also contributed to the ensuing surge in inflation in 2021-2022.

The looming issue for 2025 is whether the Tax Cuts and Jobs Act of 2017 will be extended and expanded as Donald Trump proposes or tax hikes on corporations and wealthy individuals will be enacted as Kamala Harris favors. The outcome could give the economy an added boost or serve as a drag.

Beyond this, assessing the budgetary impacts of the presidential campaign plans is particularly challenging now.

Many of Kamala Harris's tax policies remain ambiguous, and she has not indicated how her spending priorities will align with the current FY2025 budget proposals. According to Bloomberg, Donald Trump is campaigning on a grab bag of tax cuts that could collectively cost as much as $10.5 trillion over a decade. However, such a high tally is highly unlikely to pass, and a portion could be offset by higher tariff revenues.

Given the vast differences in economic policies, it is difficult to assess their economic impact now. Nonetheless, once the election results are in and the fiscal policy outlook comes into focus, the Federal Reserve will need to weigh the implications for the economy and the conduct of monetary policy.