The first cut is the deepest

After nine weeks of hype, the Fed delivered 50 bp. Here are my four takeaways.

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Two 25 bp cuts in one go

The simplest explanation for the jumbo-sized cut is that the Fed regretted not cutting in July and was making up for lost time. Recall that after the July meeting, inflation remained benign, and labor market data weakened further. Moreover, ?the BLS had released preliminary benchmark revisions for payrolls, suggesting a likely 800k-plus level shift. As I’ve noted at the time, with the benefit of hindsight, the Fed probably regretted remaining on hold at that meeting.

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Looking ahead, both the SEP forecasts and Powell’s press conference underscored a return to more normal 25 bp per meeting cuts (Exhibit). Powell repeatedly talked of “recalibration.” The median “dots” suggest two or three 25 bp cuts in a row followed by a bit over a year of cuts at every other meeting. This confirms that the Fed still believes in gradualism, even if the first cut is the deepest.

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Starting with 50 bp has not changed the growth and inflation outlook

If the Fed was hoping for a significant boost to financial conditions, the market did not cooperate. Two-year yields were roughly flat, ten-year yields rose 4 bp and the stock market dipped slightly. A day later and stocks are up a bit over a percentage point and bond yields have risen a bit further. Of course we can’t be sure about the counterfactual: had the Fed cut by 25 bp would there have been a drop in stocks or would markets be assured that the Fed was not worried about a recession. Either way, no one is changing their forecast based on the Fed’s decision.

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I remain puzzled by the oversimplified discussion of how Fed policy impacts the economy. Most commentary focuses on the r-star spread—the real funds rate relative to the neutral r-star.

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There are three problems with this commentary:

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First, often analysts (and Fed officials!) use the wrong measure of inflation to calculate the real rate. What matters to the economy is not nominal interest rates relative to past inflation, but interest rate relative to expected inflation over the duration of the loan or investment. The difference between lagged and expected inflation has been very high in the last few years.

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Second, estimates of r-star are highly uncertain. Even the fanciest econometric models of r-star have huge standard errors. Moreover, they produce estimates that are dominated by the average funds rate over recent years. Interest rates were very low from 2009 to 2021 -- hence r-star is very low. QED.

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Third, and most important, the direct impact of the funds rate on the economy is quite small. The funds rate only really matters for some kinds of short-term loans. In the real world, monetary policy also works through long-term borrowing costs, asset prices, the exchange rate, credit availability, credit spreads, confidence and so on. Overall financial conditions remain supportive of growth and suggest a low risk of recession, regardless of what the r-star spread is saying.

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Powell is not Greenspan

Most economists, including yours truly, thought a 25 bp cut was more likely than a 50 bp cut. (Kudos to Neil Dutta for nailing the 50 bp call!). My own thinking was that historically, Fed chairs —including Powell — move in 25 bp increments unless the economy or markets are moving quickly. This is particularly the case for the first step in an easing or tightening cycle. Indeed, under Powell, the Fed’s first hike in 2022 was 25 bp even though the Fed was much further behind the curve in fighting inflation than it is now in preventing a recession.

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A related difference is that Powell seems a bit less concerned about surprising the consensus. His commentary prior to the meeting was ambiguous in terms of the size of the move. Past Fed chairs tended to work harder to signal an unusual move. Powell seemed comfortable leaving the decision to the meeting and moving ahead even with a dissent from a Governor. Recall that in the past decade or so dissents are not unusual for Presidents, but a Governor has not dissented in many years.

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I don’t think these tactical changes are necessarily bad. It is not the end of the world if economists and the markets are mildly surprised by a move. And the Fed’s obsession with “gradualism” and avoiding “flip flops” always seemed a bit overdone to me.

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A big contradiction

I still don’t think the Fed’s forecast adds up in one important respect. While the median FOMC estimate of nominal r-star has inched up from 2.5 to 2.9%, the median predicted policy path still implies one of the tightest policy periods in Fed history. If the Fed’s r-star estimate is correct, then policy will be tight for 43 consecutive months (again, see exhibit above). Moreover, for 30 months the funds rate will be more than 1% above the alleged neutral and for 17 months it will be a growth-crushing 2% above neutral. And yet the median forecast is for a near perfect soft landing for the economy—with growth bottoming at 2% and the unemployment rate essentially flat.

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Perhaps the Fed is assuming a short-run r-star that is much higher than their long-run estimate. That made sense when the economy had a lot of post-pandemic pent-up demand in 2021- 2023. However, it is not clear to me what factor would keep the short-run r-star high today.

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In my view, the way to square this circle is to assume a significantly higher r-star. This makes sense given how easy financial conditions are and how well the economy has weathered the Fed’s “crushingly tight” policy. I still expect that Fed’s estimate of r-star and the actual funds rate to converge to about 4%.

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In sum, it is time to move away from the obsessive Fed focus. My coming posts will focus mainly on the economy and that other obsession--the election.