On December 18, the Federal Reserve Board announced a 25-basis point drop in its target for the federal funds interest rate. For the uninitiated, banks are required to maintain a certain level of reserves. On a daily basis, banks borrow and lend to each other using the fed funds market to facilitate transfers from those banks with excess reserves to those needing additional reserves to satisfy their reserve requirements. The Fed’s target for this rate is a key policy variable that signals the direction of monetary policy.
Generally, raising the target is indicative of tightening monetary policy, while lowering the target reflects monetary easing. That generalization can be misapplied, however, in cases where the Fed is reacting to changes in relative interest rates. That is, sometimes the Fed’s action pushes interest rates in one direction or another, and other times the Fed plays catchup, whereby it adjusts its target rate to reflect changes that arise in other credit markets.
So how should we read the latest change? Do we take this measure to lower the Fed’s target as an indicator of monetary policy easing, or was it a calibration to maintain a more normalized relation between the fed funds market and others?
In his speech announcing the target rate cut, Chairman Powell reiterated the oft-repeated dual mandate of the Fed to pursue full employment along with price stability, stating that concerns of these respective objectives were “roughly in balance.” Given the state of inflation and unemployment, that characterization seems apt, suggesting little need to tilt monetary policy one way or the other. Put another way, the latest data offer little justification to commit to either easing or tightening monetary policy, especially since working to improve on one of these policy fronts would likely be to the detriment of the other. Given Powell’s setup, it’s reasonable to ask why the rate target was reduced when neither of these two considerations demanded a greater weight in the monetary policy decision.
The reduced target rate is all the more perplexing given recent developments in credit markets. Let’s look at the history: Prior to the start of the COVID pandemic, the fed funds rate had been trading in the range of 1.5% or so; but by 2020 Q2, this rate fell and remained near zero until mid-March 2022, at which point the Fed began raising the fed funds target rate. Between March 2022 and July 2023, the Fed hiked this target 11 times, elevating it to a range of 5.25% to 5.50% on July 26, 2023. Since then, the Fed made a 50-basis point reduction of this target range in September of this year and another 25-basis point decline this week, putting the current target range at 4.50% to 4.75%.
The September rate cut was explained as a response to seeing continued improvement in inflationary statistics coincidently with some indications of weakening in labor markets. Since then, however, the improvements on the inflation front appear to have stalled if not worsened somewhat. Meanwhile, since the September action, interest rates for maturities longer than one year have generally gone higher over the last three months. With these higher interest rates, it’s not at all clear why the Fed would want to push the fed funds rate in the opposite direction. Also worth noting is the fact that the spread between the rates on the 10-year bond and 3-month bills just moved into positive territory after being negative for more than two years. This spread is particularly interesting in that many see a negative value for it as suggesting a heightened risk of a forthcoming recession. With this spread moving into positive territory, that risk appears to have been mitigated to a considerable degree.
It’s not just the latest reduction in the Fed funds rate target that is confounding, it’s also that Chairman Powell explicitly offered that he was anticipating two further rate cuts in the coming year – down from the four expected target rate reductions that had been communicated just three months ago. Such forward-looking indications probably were at the root of this latest rate cut.
Having emphasized that future policy decisions would be driven by the data, Powell was suggesting that expectations about future target rate cuts would not be binding. Still, by articulating such forward-looking projections, the Fed is fostering more broadly-based expectations on the part of the public, and it’s reasonable to assume that the Fed would have to be somewhat sensitive about acting in ways contrary to consensus market opinions. I tend to believe that the Fed likely saw not following through with a cut in this target rate this December as jeopardizing its credibility. Unfortunately, by continuing to make public these forward-looking projections, the Fed has set itself up for more of the same at future decision points.
Powell characterized this latest move not as an easing of monetary policy, but rather as the maintenance of a still restrictive policy — albeit less so. I see this representation as a semantic dodge. A clearer roadmap is in order – one that recognizes that, the dual mandate notwithstanding, the Fed can fight only one battle at a time – easing monetary policy to increase employment or tightening policy to dampen inflation; and it should wait until one of those areas definitively shows itself to be the greater concern. Failing that, the best course would be the status quo, i.e., allowing the private markets to work their magic without interference.
The nightmare scenario that I’m most worried about, however, is one where Trump is able to follow through on his promises of broadly-based tariffs, massive deportations, and substantial reductions in the civil service labor force, all of which could have the Fed trying to address its dual mandate when both inflation and unemployment are at significantly higher levels than they currently are, today.
