Federal Reserve Chair Jerome Powell left financial markets in suspense ahead of Halloween, warning that a data fog could prompt monetary policymakers to temporarily pause the current easing cycle. Heading into the pre-Christmas meeting, the central bank will continue to fly blind as key economic reports will not be released until after the two-day powwow. Still, investors are betting that Santa Powell will deliver a third consecutive quarter-point interest rate cut for all the little boys and girls on Wall Street.
But is a rate cut necessary? That is the consensus, it seems, but many signs point to a rate hike.
The Federal Reserve Talks
Where’s the tariff-driven inflation? That is what Fed Governor Christopher Waller wants to know.
“People said tariffs are going to cause a bunch of inflation. It ain’t happening. It should have already happened. So start giving me a lot better reasons for not cutting rates,” Waller said at a recent event. In a Nov. 24 Fox Business interview, Waller reiterated that he does not believe inflation will be a significant problem going forward. His fear? The labor market. "So, I'm advocating for a rate cut at the next meeting," he said.
For months, Waller has purported that it would be appropriate for the US central bank to lower interest rates, pointing to the lack of tarifflation in the economy and the further deterioration in the labor market. Right now, Waller thinks tariffs will be a one-off, but employment conditions will turn around in the next several months. Suffice it to say, there is a reason he has been one of the heavyweight contenders to replace Powell next year.
Stephen Miran, President Donald Trump’s temporary appointee to the Fed Board of Governors, wants to take it a step further and cut interest rates by 50 basis points next month. He believes the US economy is doing well, but a more aggressive approach to rate cuts can prevent a downturn, especially given the long and variable lag effect of monetary policy.
But while nobody at the Eccles Building is entertaining the idea of tightening policy, there is a contrarian case to be considered that the Fed should be thinking of raising interest rates instead.
Dashboard Indicators
If you have not been paying attention to the economic data or Wall Street, a checkup is in order.
The Fed has missed its 2% inflation target for more than five years, with the annual inflation rate hovering around 3%. Or, if you want to rely on the central bank’s preferred Personal Consumption Expenditures (PCE) Price Index, then 12-month inflation is running at 2.7%.
Despite the recent selloff, US stocks are still close to their all-time highs. The blue-chip Dow Jones Industrial Average recently touched 48,000. The tech-driven Nasdaq Composite Index has registered double-digit gains this year, while the broader S&P 500 is also hanging around record levels. Of course, it feels like one of the most cautious bull runs in recent memory as bears and bulls mull over the artificial intelligence (AI) bubble.
Home prices and rental costs are at or near all-time highs. Gold is still firmly above $4,000 per ounce. The US dollar is gradually bouncing back after touching a bottom this past summer. The only asset bubble that appears to be deflating is bitcoin, but history shows that for every sharp downturn, there is a massive reversal leading to new highs.
The world’s largest economy is poised for 4% growth in the third quarter and potentially another 2% expansion in the final three months of 2025. The data suggest employment conditions are slowing, but the unemployment rate remains at historically low levels.
So, why is the United States in desperate need of interest rate cuts?
Blinded by the R-Star
Perhaps one reason why the Fed has essentially dismissed the contrarian measure of rate hikes is the R-star. This is the natural interest rate, also known as the neutral rate, which neither stimulates nor restricts economic growth amid stable inflation.
Monetary policymakers analyze the R-star – first introduced in 1898 by economist Knut Wicksell – in various ways, making the concept challenging to apply objectively. Indeed, there are a few methods for calculating R-star.
The most common is the Laubach–Williams Model from 2003, which depends on a statistical model that incorporates inflation, gross domestic product, and the federal funds rate. It removes cyclical movements from structural trends, helping to estimate possible output growth and the neutral rate. In recent years, Fed officials have also turned to market-based approaches, primarily by examining long-term inflation-adjusted bond yields.
According to Miran, all evidence suggests the R-star is lower than his colleagues have estimated, indicating that the rate-cutting cycle should persist well into 2026.
Lump of Coal
The chances of a rate hike in December or anytime next year are as low as Mariah Carey’s All I Want for Christmas Is You not causing any seizures during the holiday season.
Of course, any allusion to a rate hike would perturb the current administration. President Donald Trump, Treasury Secretary Scott Bessent, and National Economic Council Director Kevin Hassett have contended that interest rates should be as much as 200 basis points lower than they are today. However, popping some bubbles and removing the final 1% of inflation out of the economy may require a higher-for-longer policy stance.
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