Fed may trip the stimulation wire

The Federal Reserve may be about to stimulate an economy growing at more than 3%, where stocks are at record highs and inflation remains above target. The problem is that no one knows for sure how far the U.S. central bank can go before it trips that wire. Putting aside the intense political pressure, the fundamental arguments for Chair Jerome Powell to resume Fed rate cuts this week rest on the softening U.S. jobs market and ongoing problems with housing affordability, as well as concerns that the economy could head south by this time next year.

The extent of the jobs trouble is debatable, however, due to a halt to immigration and the ‘weakness’ may have as much to do with labor supply as demand. The housing market also remains slightly distorted because the extraordinary drop in mortgage rates during the COVID-19 pandemic is making homeowners loath to sell. On the flipside, U.S. retail sales are still booming at an annual rate of 5%, the stock market has roared to record highs, broad financial conditions are the loosest in three years and inflation continues to run hot above target – whatever one assumes the enduring impact of trade tariffs.

Given this mixed bag, the Fed’s best course of action may be to shift to neutral – a rate that neither spurs nor inhibits the economy. But, as ever, determining precisely where that holy grail may be is a complex and wonky task. By some measures, a quarter-point cut this week would already push the Fed close to or even below neutral territory. A 50-basis-points (bps) move today, or the second 25-bps move in October that is currently 80% priced into markets, could already move the Fed into stimulative mode, raising questions about whether White House demands are already trumping traditional Fed assessments.

If only it were that simple.

SPECIAL GUEST STAR

A long-standing Fed model for determining the notoriously elusive neutral real rate – the Laubach-Williams gauge jointly developed by New York Fed boss John Williams – estimates this figure, dubbed ‘R-star’, is currently 1.37%. If the midpoint of the Fed target range were to fall 25 bps to 4.125% later today, then the prevailing real funds rate based on the most recent core PCE annual inflation rate from July would fall to 1.225% – so mildly prodding but not super stimulative. However, if consensus forecasts for core PCE in August play out at 2.7%, then the resulting real funds rate would remain a drag at 1.425%, reinforcing calls for more cuts. But doves point to a revised R-star model from 2023 that is adjusted for pandemic-related supply distortions. It puts the neutral rate as low as 0.85%. Indeed, Williams himself recently suggested ‘growth-adjusted’ R-star may still be stuck around pre-COVID levels as low as 0.5%.

Assuming the revised Holston-Laubach-Williams estimate is the more correct reading, then policy would still be restrictive by at least 50 bps following a quarter cut today – and two more similar cuts by year-end would only then bring it back to neutral.

What’s more, if something close to the Fed policymakers’ median core PCE forecast of 2.2% for next year pans out, then a further 50 bps of easing would be warranted in 2026 just to remain neutral.

In total then, some 125 bps of cuts through the end of next year would likely do the trick. Markets are priced for 150 bps, suggesting they assume the Fed will move into a stimulative mode by then.

So two models, and two very different narratives.

FED PLOTLINES

So much for the models. Watching what Fed policymakers themselves think may be more important – not least with changing personnel on the central bank’s board. With the caveat that the Fed’s ‘dot plot’ predictions will be updated later today, the standing view from June’s forecasts shows that Fed officials anticipated two cuts this year. Their equivalent ‘neutral’ long-term policy rate is 3%, translating into a 1% ‘R-star’ estimate.

Much of the focus on Wednesday will be on whether the median projection goes to three cuts from two this year – as markets are not yet fully priced for that shift.

But as it stands, a 1% long-term real neutral policy rate assessment is higher than the HLW model and that part of dot plot may well have an impact on market thinking today too.

With politics weighing heavily over the central bank, all this ‘science’ may end up being beside the point. President Donald Trump’s eye-popping demand for 1% policy rates suggests he has little time for models. Either that or he really meant to say 1% real rates, which would instead mean he thinks rates should really move quickly to 3.7%.

If that were true, then perhaps he’s not so far off from market pricing or the Fed’s direction of travel – but that’s a very big “if”.

The opinions expressed here are those of the author, a columnist for Reuters