The Federal Reserve's interest-rate decision this week looks more difficult than it should be. The real question isn't how much to cut, but where rates ought to be. The answer is much lower. That argues for a half-point cut.
The case for a bigger cut starts by examining why the Fed's short-term rate target is now 5.25% to 5.5%, the highest since 2001. The Fed pushed it there last summer because underlying inflation was well above 3% and, with the labor market overheated, the Fed was afraid it would get stuck there. It was willing to cause a recession to prevent that.
Fast forward to today, and some key underlying measures of inflation are below 3%, some within range of the Fed's 2% target. The labor market is cool, if not actually cold. A recession now serves no useful purpose.
True, there isn't much evidence a recession is in the offing. But waiting for that evidence is tempting fate.
Inflation victory is in view
A year ago inflation as measured by the consumer-price index was 3.2%. In August, it was 2.5%. In that time, core inflation, which excludes food and energy, has fallen from 4.2% to an estimated 2.7%, using the Fed's preferred gauge, the price index of personal-consumption expenditures, or PCE.
The gap between 2.7% and the Fed's 2% target largely reflects the lagged effects of higher housing, auto and other prices from a few years ago. Some alternative indexes attempt to exclude such idiosyncratic factors. Harvard University economist Jason Furman averages several over different time horizons to yield a single, PCE-equivalent underlying inflation rate. It was 2.2% in August, the lowest since early 2021.
Inflation is likely to keep falling. Oil has plunged from $83 a barrel in early July to below $70 on Friday. This will directly lower headline inflation and, indirectly, core inflation because oil is an input into almost every business. A study by Robert Minton, now at the Fed, and Brian Wheaton at the University of California, Los Angeles, found oil can explain 16% of fluctuations in core inflation, and it takes two years for 80% of the effect to show up.
Inflation-indexed bonds and derivatives now project CPI inflation at just 1.8% in the coming year and an average of 2.2% in the following five years, according to the Intercontinental Exchange.
This matters for two reasons. First, it means investors are confident the Fed will hit its 2% target. In fact, it implies some chance inflation falls below target, something the Fed shouldn't welcome.
Second, the real cost of borrowing equals the nominal interest rate minus inflation. As expected inflation falls, the real short-term interest rate has risen, to between 3.2% and 3.5%.
That is restrictive by any measure. Fed officials think the "neutral" real rate, one that pushes employment and inflation neither up or down, is 0.5% to 1.5% -- at least 1.75 percentage points from here. In 2022, the Fed raised rates in half- and three-quarter-point increments because its starting place, deeply negative real rates, was so far from neutral. The same logic should apply now, in the opposite direction.
The labor market is plenty cool
High real rates could be justified to weaken economic activity and bring inflation down. But with inflation already headed lower, that need has passed. Meanwhile, the labor market is cooling rapidly. The unemployment rate rose from 3.5% in July 2023 to 4.3% a year later, touching off a panic because in the past, such an increase meant the U.S. was in recession.
False alarm. Nothing about consumer spending, unemployment insurance claims or the stock market points to an economy in trouble, and unemployment ticked down to 4.2% in August. Yet the data give no reason to worry about inflation pressure, either. Just the opposite: The number of vacant jobs per unemployed person has slid from two in early 2022 to 1.1 now, below the prepandemic norm. Monthly private-sector job growth averaged just 96,000 in the last three months, also below the prepandemic norm. This suggests wages, still growing faster than before the pandemic, are bound to slow.
What mistake would you rather make?
The Fed doesn't get to wait for perfect knowledge before acting. It always risks doing too much, or too little. The question is, which is worse? Cutting rates half a point isn't riskless. Long-term Treasury bond yields are already lower than short-term rates -- a relationship called an inverted yield curve -- and could fall even further, pulling down mortgage rates. Stocks could turn frothy. That would stimulate spending.
Inflation could also prove stickier or even edge higher, especially if oil rebounds or tariffs are raised. If that happens, the response should be straightforward: Don't cut again. Rates would still be relatively high.
Cutting only a quarter point looks riskier, though. One reason oil and other commodity prices such as copper have fallen is because the global economy, in particular China and Europe, looks sickly. Mounting auto loan and credit card delinquencies show higher rates are biting. The yield curve is inverted because markets think interest rates ought to be lower.
The Fed has already erred on the side of moving slowly. In hindsight it should have cut in July given the weak employment and generally tame inflation data that followed. If the Fed only cuts a quarter point now and more weak data arrive, it would be even further behind the curve.
Some analysts suggest that in a close call, the Fed should cut by just a quarter to avoid the appearance of helping Vice President Kamala Harris so close to the election. But that would amount to helping former President Donald Trump.
Fed Chair Jerome Powell has insisted he would never allow political considerations to sway what should be an economic judgment. Don't bet on him starting now.