Are doves taking over the Federal Reserve from the hawks? Two key US central bankers have signaled they support interest rate cuts, contradicting Chair Jerome Powell at the Eccles Building. Fed Governor Christopher Waller recently said on CNBC that he would endorse a rate cut “as early as July.” Fed Vice Chair for Supervision Michelle Bowman would vote for a reduction to the benchmark federal funds rate next month if the inflation numbers remained subdued. Others, meanwhile, still advocate for patience until they see clearly now that inflation is gone. Who is right? It depends on who believes in the work of legendary economist Milton Friedman on monetary theory.
Interest Rates and the Lag
In the middle of the 20th century, Friedman opined that monetary policy operates with a long and variable lag, meaning that it can take an indeterminate amount of time for Federal Reserve actions to be fully reflected in the economy. Friedman purported that it could take as long as two years. "We know too little about either these lags or about what the economic situation will be months or years hence when the chickens we release come home to roost, to be able to be effective in offsetting the myriad of factors making for minor fluctuations in economic activity," Friedman told Congress in 1959.
Over the last few years, long and variable lags in Fed policy have been called into question. Since global financial markets and the overall marketplace have access to millions of data points and the US central bank provides forward guidance, it can be easier to telegraph policy actions and bake them into the cake.
Regardless of the lag effect, this is the de facto creed of the Federal Reserve System. At an Economic Club of Washington event in July 2024, Powell reiterated the Friedman philosophy, asserting that if you wait to achieve specific objectives, such as bringing inflation all the way back down to 2%, then you may have waited too long.
So, why does something the free-market acolyte wrote about 60 years ago matter today?
Running Out of Patience
President Donald Trump has repeatedly urged Powell to lower interest rates, going as far as assigning derogatory nicknames to the Fed head, from “numbskull” to “dumb guy.” Trump thinks the institution should lower interest rates by as much as 2% to juice the US economy and save the federal government $1 trillion in debt-servicing costs.
Will the Fed bite? At the June Federal Open Market Committee (FOMC) policy meeting, officials voted to keep the benchmark federal funds rate unchanged in a range of 4.25% and 4.5% for the fourth consecutive meeting. The updated Summary of Economic Projections, a survey of officials and their expectations for policy and the economy, suggested two rate cuts by the year’s end. However, the quarterly report revealed that seven of the 19 participants think there could be no reductions in 2025.
Based on the post-meeting statement, risks of higher inflation and rising unemployment are “still elevated.” Additionally, minutes from the May meeting signaled that economists anticipate a slowdown in growth later this year. If the worst comes to pass – the president’s sweeping global tariffs slow economic growth and trigger higher unemployment – then wouldn’t the Fed need to cut rates right now to account for the long and variable lag? Waller undoubtedly thinks so, telling CNBC’s “Squawk Box” on June 20
“People love to talk about long and variable lags. Why do we want to wait until we actually see it crash before we start cutting rates? So I’m all in favor of saying maybe we should start thinking about cutting the policy rate at the next meeting, because we don’t want to wait until the job market tanks before we start cutting the policy rate.”
Indeed, while the US labor market is not crashing like many economists had forecast earlier this year, labor conditions are softening. Sure, businesses are not laying off scores of workers, but they are also freezing their hiring efforts. In addition, the unemployment rate for new graduates is 7%, Glassdoor's employee confidence index tanked to an all-time low in May, and the monthly jobs report is still spotlighting downward adjustments to the non-farm payroll numbers.
According to President Trump, even if inflation rears its ugly head, the Fed could react immediately and start raising interest rates. Remember, it took inflation reaching 8% for the central bank to tighten monetary policy, which might have been the biggest fumble in the history of the Eccles Building.
Jetlag
Let’s be clear: interest rates should not be left to a centralized entity like the Federal Reserve. Rates should be a function of the free market rather than a dozen of the “smartest men and women in the room.” That said, based on the politics of a supposedly independent institution, consistency is crucial. So, not lowering interest rates confirms that it is indeed a political organization rather than a paragon of autonomy and virtue, and free from the toxicity of Washington politics.
Is a July rate cut coming? Investors still believe September is the likely time for restarting the easing cycle that started in … September 2024.
This is what it feels like when doves cry.
