The Fed needs to avoid becoming passive aggressive

The writer is chair and chief executive of Caxton Associates

While the chair of the Federal Reserve Jay Powell has indicated “the time has come . . . to adjust” monetary policy, the magnitude and pace of US interest rate cuts remains undefined. I believe there is a case for a swift and significant reset lower.

The Fed, unlike other central banks, has legal dual mandate objectives for price stability and maximum sustainable employment. Given that Powell has stated confidence in inflation progressing towards the 2 per cent objective, attention is now focused on the labour market outlook.

To my mind, Powell made his position clear at the recent Jackson Hole meeting of central bankers, stating “we will do everything we can to support a strong labor market”. This has echoes of forceful language that in the past has preceded the reorientation of central bank policy, such as Mario Draghi’s famous assertion in 2012 that the European Central Bank would do “whatever it takes” to preserve the euro.

Adjusting policy in a timely manner to sustain economic expansions is a difficult task. Powell has cited those occurring in 1965, 1984 and 1994 as soft landings. Alan Blinder has also described the 1999-2000 episode as “softish”. Soft landings are rare indeed, with the alternative being recession.

While all cycles are unique, the soft landings cited above had monetary policy commonalities. In 1984, rates were eased by more than 3 percentage points in four months, in 2001 by 2.75 points in the first half of the year, with a 1 point cut in January alone. 1995 stands out for the gradual adjustment of 0.75 points in seven months. But this glosses over the fact that 1.5 points of anticipated rate increases at the end of the cycle did not occur and five-year Treasury yields fell by nearly 2 points from the last rise through the first cut. In comparison, today’s five-year Treasury yields have sat in a close range over the past two years, and are only 0.5 points or so below the levels of the last increase.

Crucially, in each instance of a soft landing, the Fed acted before the labour market had deteriorated meaningfully. In these cases, the unemployment rate had increased by only 0.1 to 0.3 percentage points before the Fed began reducing rates. Whatever vagaries have driven the near 1-point increase in this cycle, the precedent is clear.

Other cycles ended with recessions. Rudi Dornbusch, the Massachusetts Institute of Technology economist, once noted that “none of the postwar expansions died of natural causes — they were all murdered by the Fed”.

Another sign of the need for a policy shift is in the housing market, a key conduit for the transmission of monetary policy to the economy. Affordability has been crushed in this cycle. According to the US National Association of Realtors, housing is at its least affordable since the mid-1980s.

The current Fed policy rate was self-evidently high enough to lower the central bank’s favoured measure of core inflation — the Personal Consumption Expenditures Price Index — from 5.6 per cent to 2.6 per cent. It is therefore much more restrictive today in real terms given rates have not come down as much. Most participants on the policy-setting Federal Open Market Committee estimate that the neutral interest rate that does stimulate or restrict the economy is in the 2.5 to 3.5 per cent range versus the current 5.25 to 5.50 per cent.

Some will question whether the Fed can or should radically alter its stance just months before the forthcoming presidential election. I would, however, ask an alternative question: can the central bank afford to stay with a policy that is no longer appropriate? By doing so it would risk its political impartiality.

The worst possible outcome for Fed independence would be for it to be forced by markets to further adjust rates between scheduled policy meetings in the weeks leading up to the election because of a clear deterioration of the labour market, or a financial event linked to the high policy rate. The September policy meeting is the last opportunity to adjust before the election.    

Given the recognised lags in monetary policy transmission of six to 12 months, the time to meaningfully reset the funds rate has arrived. The Fed will remain data-dependent and forthcoming economic releases are as unpredictable as ever. But rather than wait for weak labour market conditions to justify more than gradual policy steps as many claim, I think the onus is to forestall them. To otherwise maintain such a restrictive stance, Fed policy will become passive-aggressive.