It's Not Easy Being the Fed

The Fed wants to preserve its independence. What does that mean for monetary policy this fall?

Photo by Alexander Grey on Unsplash

Today the Federal Reserve is poised to cut interest rates for the first time in over two years. That makes sense, as inflation has dropped considerably over the past year while the unemployment rate has risen by a full percentage point. As NBC News reported yesterday, the only question is whether the cut will be 25 or 50 basis points:

A reduction to the central bank’s federal funds rate serves as a benchmark for other borrowing costs throughout the economy. And while that move has been widely anticipated, investors have been unable to predict how large the cut will be.

On Tuesday, a survey by CNBC correspondent Steve Liesman showed a majority of respondents forecasting a 0.25% cut from the current 5.3% level, even as Wall Street traders said it was more likely that the central bank would issue a 0.5% cut.   

The Fed tends to move in 0.25% increments — and until recently, there was general agreement that it was likely to lower the rate by that amount. But a series of data points showing worsening economic conditions has made some analysts believe a 0.5% cut is more likely — and perhaps even necessary.

One of the reasons everyone knows the Fed is going to cut interest rates is that Federal Reserve chairman Jerome Powell has said that this will be happening. Powell telegraphed the Fed’s intentions in his big speech last month in Jackson Hole:

Overall, the economy continues to grow at a solid pace. But the inflation and labor market data show an evolving situation. The upside risks to inflation have diminished. And the downside risks to employment have increased. As we highlighted in our last FOMC statement, we are attentive to the risks to both sides of our dual mandate.

The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.

We will do everything we can to support a strong labor market as we make further progress toward price stability. With an appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2 percent inflation while maintaining a strong labor market. The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions.

Powell’s speech is known in the business as “forward guidance.” Powell and other Fed officials often try to reduce volatility and set expectations by signaling in advance where Fed policy is likely to go in the future. Forward guidance has been a tool of Fed policy for more than twenty years.

All of this background is what makes this Michael Toth’s recent Wall Street Journal op-ed so puzzling. The headline is, “It’s Too Close to the Election for the Fed to Cut Rates”:

The Federal Reserve has historically left interest rates alone in the months before a presidential election. Chairman Jerome Powell and his colleagues have signaled that they are ready to break that norm when they meet this week. They shouldn’t. 

Since 1990 the Fed has cut rates in the final two months of a presidential campaign only three times. Each case shows why rate cutting in the homestretch of the political season is exceptional….

At his nomination hearing in 2017, Mr. Powell promised that like Ms. Yellen, he would “do everything in my power” to preserve the Fed’s “independent and nonpartisan status.” If he’s serious about that pledge, he should hold fast on rate cuts. After this week, the Fed’s next meeting is the day after the election. Preserving the Fed’s independence through the next administration is worth the six-week wait. 

The thing is, nowhere in Toth’s op-ed is there any discussion of forward guidance. It would be far more problematic for Powell to not follow through on a rate cut he promised last month than to go ahead as scheduled.

Toth’s op-ed seems like concern trolling of the first rank. The evidence of a slowing job market is perfectly self-evident, as is the evidence of cooling inflation. Monetary policy often takes months to be felt in the real economy. Delaying rate cuts simply because of the approaching presidential election makes little sense, and reflects an antiquated understanding of the Fed.

That said, Toth’s desire for the Fed to preserve its independence makes a great deal of sense. The person he should be excoriating on that front, however, is Donald Trump. Back in July it was Trump who warned Powell not to cut rates before the election, while at the same time promising a “lot of cutting” from the Fed if he was elected.

Forbes’ Derek Saul recently reviewed what the candidates have had to say about Fed policy, and you’ll never guess which of the major party candidates has threatened the independence of the Fed:

Trump made further waves in August when he proclaimed the president should have a “say” in Fed decision making, saying he specifically is qualified because he “made a lot of money” and has “better instinct than…people that would be on the Federal Reserve or the chairman,” though Trump later walked back the stance by saying the Fed staff doesn't “have to listen” to him.

Mostly tight-lipped on the Fed, Harris responded to Trump’s initial insinuation in August by reaffirming the Fed as an “independent entity” and vowing to “never interfere in the decisions that the Fed makes” if elected president.

To the hard-working staff here at Drezner’s World, the best way for the Fed to protect its independence is not be bullied by the candidate threatening to end Fed independence.

Politico’s Victoria Guida noted another wrinkle for Powell in the next few months before the election — mapping out the relevant policies that might get implemented depending on whether Harris or Trump wind:

The Fed may move more cautiously this week at least in part because policymakers want to know the outcome of the election before acting more decisively….

Fed Chair Jerome Powell is adamant that the central bank’s interest rate decisions will never be based on politics, only on the economic outlook.

Unfortunately for him, that’s why the upcoming election still matters.

It’s harder to answer the question of what will happen to the economy without some sense of who might occupy the Oval Office, and who will control Congress, come January. And while Powell has made clear that the central bank doesn’t make policy based on politicians’ campaign promises, the outcome of an election is another data point — more lasting than this month’s jobs numbers or inflation report — that provides a signal of where the country is headed….

Different election results could put immense pressure on the Fed, but the details matter.

Donald Trump has threatened to put across-the-board tariffs of 10 or 20 percent on all imports — and 60 percent on goods from China — which could feed inflation by increasing costs for consumers. That could prompt the Fed to eventually hike interest rates. Or, it might lead to slower growth, which is what happened during Trump’s first term. The central bank responded then by lowering rates slightly in 2019 in an effort to avoid a recession.

So put me down for a 25 basis point reduction with forward guidance of more rate cuts. Contra Toth, that would be the best way to simultaneously display Fed independence while still hedging the Fed’s bets for the future.