At the Federal Reserve's annual symposium in Jackson Hole, Wyoming, last week, several policymakers made the case for advancing interest rate cuts in a "gradual" and "orderly" manner. This approach contrasts with investors' expectations of at least one substantial rate cut this fall.
Federal Reserve officials stated that inflation has not yet fully reached the 2% target. Although the labor market has shown some signs of weakness, they believe that aggressive measures are unnecessary for now, as there have been no widespread layoffs.
Brett Ryan, a senior U.S. economist at Deutsche Bank, noted, "Gradual, orderly, and cautious—these are terms policymakers often use in dealing with economic transitions. This will be a step-by-step process, and they prefer a slow and steady approach."
The Federal Reserve typically adopts a gradual strategy during uncertain times. This suggests that they may opt for a 25 basis-point rate cut at a time. However, Federal Reserve Chairman Jerome Powell has not explicitly endorsed this strategy.
Powell’s dovish stance
Federal Reserve Chairman Powell aims to reduce inflation without causing significant harm to the job market. In his highly anticipated speech at Jackson Hole, he did not explicitly outline the Fed's rate cut pace expected after September. However, if the employment situation rapidly deteriorates, Powell seems more inclined to take bolder action than some other officials.
Powell stated, "While ensuring price stability, we will strive to support a robust labor market. We do not seek, nor do we welcome, further labor market slowdown."
Throughout modern history, the Federal Reserve has generally favored a gradual approach during both loosening and tightening cycles, with few exceptions. During the financial crisis and the COVID-19 pandemic, policymakers swiftly reduced rates to zero. Similarly, in the late 1970s and early 1980s, former Fed Chairman Paul Volcker was known for his aggressive anti-inflation measures. Apart from such periods, monetary policy typically adjusts by 0.25 percentage points at a time.
As then Fed Governor Ben Bernanke mentioned in his 2004 speech on gradualism, this approach allows policymakers time to assess the economy's response to their actions.
If a gradual rate cut strategy is adopted, it will somewhat mitigate current tightening policies while considering that the inflation target has not yet been reached. Given that the Fed underestimated the price surge in 2021 and delayed tightening, some policymakers remain cautious about an inflation rebound. They worry that lowering borrowing costs may unleash pent-up consumer and business demand, waiting for lower rates.
Meanwhile, the labor market seems to be normalizing and showing some weakness. In July, the unemployment rate unexpectedly rose to 4.3%. Although employers have not implemented widespread layoffs, the pace of hiring has significantly slowed down.
Richmond Federal Reserve Bank President Barkin believes this situation might not persist for long.
Claudia Sahm, chief economist at New Century Advisors, pointed out, “When it comes to labor market weakness, policymakers now face a critical question—they need to start removing some restrictions.”
Powell and his colleagues have long believed that an overheated job market drives up wages, enhancing the purchasing power of American consumers and fueling inflationary pressures. However, Powell has clearly indicated that this impact is diminishing.
EY-Parthenon economists Gregory Daco and Lydia Boussour stated, "Powell's stance appears more dovish than that of his colleagues. However, unless the employment situation significantly deteriorates in the coming weeks, we still expect most policymakers to support a 25 basis-point rate cut in September."
What about the pace and extent of rate cuts?
As the Federal Reserve moves into the next phase, they face another challenge besides the pace of rate cuts: what level should rates ultimately be reduced to if all goes well?
The so-called neutral rate—the rate at which the central bank neither restrains nor stimulates the economy—is only an estimate, not an exact science. Some Fed officials and economists believe that in the post-pandemic economic environment, with increased labor productivity, this level may be higher than in the past.
Given this uncertainty, a gradual rate cut approach appears more attractive.
Barkin noted that if officials could pinpoint the neutral rate accurately, they could stop rate cuts and declare their mission accomplished there. However, real-life situations are often more complex.
He stated last week, "You need to navigate through this process. You will continually learn and adjust based on whether inflation is stabilizing or accelerating, and whether the labor market is growing or shrinking."
Other Fed officials, like San Francisco Fed President Daly, believe it is premature to discuss the neutral rate now.
In an interview, she said, "What is crucial now is to ensure that even as we adjust policy rates, they remain at restrictive levels. We still have a long way to go."
