The Federal Reserve’s policymakers ought to ask why, with inflation stuck at 3%, investors have so confidently priced in at least two further interest-rate cuts starting today.
The case for these cuts is far from clear. The economy is behaving unpredictably and the government shutdown is blocking essential data. Yes, the labor market is cooling. Yet the dissonance of persistently higher-than-target inflation, a remarkably opaque economy, and investor complacency over a decision to ease is worrisome. Investors might soon start thinking that the Fed, despite pledges to the contrary, is fine with 3% inflation indefinitely.
Powell and his team deserve sympathy and support. They’re grappling with problems not of their making — above all, uncertainty due to the administration’s fluctuating tariff policy and its aggressive moves against central-bank independence. Yet this additional confusion is another reason to be cautious about relaxing policy. Investors see no such hesitation. Guided by the Fed’s “dot plot” and officials’ recent comments, they’ve assigned probabilities of more than 90% to cuts of 25 basis points today and again in December.
Perhaps the Fed will pause. But if it goes ahead, and you knew nothing about its mandate, what would you suppose its inflation target to be? Core PCE inflation (the central bank’s preferred measure) fell to 3.1% at the end of 2023. Two years later, it’s still roughly 3%. Private forecasters surveyed by Bloomberg expect it to be only a little less than 3% a year from now. Forecasts of unemployment have edged higher but are still consistent with “full employment.” And forecasts of output in the current year are higher than before. Given all this, the Fed is cutting rates? You’d be forgiven for assuming that its inflation target is 3%, not 2%.
Working backward from other benchmarks, you’d conclude much the same. For instance, the Fed says the long-term real interest rate is 1%. With inflation at 3%, that suggests a neutral policy rate of 4%, which is about where it stands. On the face of it, merely leaving the rate alone would indulge inflation at 3%; cutting it hardly signals commitment to the 2% target. In the same way, Taylor-rule calculations based on an inflation target of 2% call for a policy rate of a little over 4% (depending on assumptions). At the moment, most Taylor-type formulas would justify an increase in the policy rate more readily than a cut.
Powell and his colleagues constantly affirm their commitment to the 2% goal. And it says a lot for their standing that they are still mostly believed, in financial markets at least. The Cleveland Fed’s market-based model shows expected long-term inflation of 2.3%. (Surveys of consumers, such as the University of Michigan’s, show much higher numbers — 3.9% for longer-run inflation, according to the latest poll — but these estimates are noisy.) Financial markets, it seems, aren’t yet questioning the 2% target. But the Fed’s revealed preference, you might say, is starting to clash with its professed commitment.
The Fed emphasizes that the “balance of risks” to its dual mandate has changed: The labor market is cooling too rapidly, it says, while inflation continues to fall slowly, thanks to a policy rate that is (and after any cuts will presumably remain) “modestly restrictive.” Both parts of this rationale are questionable. Hiring has dropped sharply, to be sure, but unemployment has barely risen. The main reason is probably that the crackdown on illegal immigration has shrunk the labor supply — implying that higher demand could raise wages, threatening more persistent inflation even though hiring is down. In addition, fiscal policy has spurred demand through the One Big Beautiful Bill’s tax cuts. Meantime, as noted, inflation is subsiding, if at all, very slowly, and a policy rate of 3.5% is arguably not restrictive at all.
It doesn’t help the Fed’s credibility that investors might come to suspect it of bending to White House pressure for cheaper money, and that the case for adopting a 3% inflation target is in fact respectable. Academic economists often point out that a higher inflation target would let the labor market adjust more flexibly to shifts in demand and make it less likely that in some future recession the so-called zero lower bound will neuter the Fed’s ability to respond. Tolerating 3% inflation indefinitely wouldn’t be crazy — especially if unemployment does keep rising.
It’s still a really bad idea, in my view, because similar arguments would be deployed in due course to justify a target of 4%, then 5%, and so forth. (What’s a slight rise in inflation if it means less unemployment?) Move away from the 2% promise and expectations would be unmoored. The new target would be less credible and future inflation would be harder to contain. Once the Fed is suspected of leaning this way, the damage will have been done — and putting it right will be costly.
At the very least, whether to cut the policy rate today is a close call for a Fed committed to a 2% goal — a fact that’s sharply at odds with investors’ near-certainty that it will happen. Whatever Powell and his colleagues decide, they should see this dissonance as proof that something is wrong with the way the Fed signals its intentions. A close call on the merits means investors should be undecided, disagreeing among themselves over what will happen and waiting to see where the Fed comes down. It also means the Fed’s policymakers should approach their discussion with an open mind. If, despite everything, cuts were already a done deal, one can’t help but wonder what became of 2% inflation.
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Read more articles by Clive Crook
