11-21-2024
Some financial sector analysts have argued that the Federal Reserve should skip cutting its policy rate at the upcoming December meeting and that markets are overestimating the additional policy rate cuts in 2025. They argue that inflation may prove to be sticky in 2025 and could even move higher. Two arguments are offered. The first is that potential policy by the incoming administration could add wind to the back of inflation. The second is that the neutral policy rate may be higher than the range of current estimates.
As to the first concern, the Fed can adjust its policy stance, if necessary, when policies are enacted and details about the policies are known. As to the second concern regarding uncertainty over the neutral policy rate, in an earlier post I suggested that the Fed could take the middle 50 percent of the range of its estimates from the September Summary of Economic Projections (SEP) forecasts. This is a range of 2.75 to 3.37. If the Fed starts with the high end of this range, then one more 25 basis point cut in the policy rate in December would have policy well-calibrated for current economic conditions.
A neutral policy rate of 3.37 percent implies a neutral real short-term interest rate, i.e. r*, of 1.37. Following the 2008 financial crisis, estimates for r* were around 0.5 percent. That is, starting with a value of 3.37 for the neutral policy rate implies that r* has almost tripled in value. There are model-based estimates of r* that currently indicate an even higher value than 1.37, but these estimates are quite imprecise and therefore not very helpful for policy. Additional support for a higher value of r* is the argument that financial conditions appear not to be very tight, so monetary policy has not been very restrictive. This would imply that “Team Transitory” was correct after all and the high inflation we experienced was going to abate on its own — it just took longer than initially anticipated. While this scenario is possible it seems unlikely.
Learning about the level of the neutral policy rate will be an important task for the Fed in 2025. This process will take time and will benefit from the decentralized structure of the Federal Reserve and its extensive contacts throughout the country. As we turn the page to a new year, much of the public’s attention will be on D.C. The Fed’s attention will continue to be on the economy.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas.
