Does the Fed even know what it’s trying to do?

Federal Reserve Chairman Jerome Powell speaks at a press conference in Washington, Dec. 18. Photo: AFP Contributor#AFP/Agence France-Presse/Getty Images
Federal Reserve Chairman Jerome Powell speaks at a press conference in Washington, Dec. 18. Photo: AFP Contributor#AFP/Agence France-Presse/Getty Images

Summary

The rate cuts are hard to explain alongside the projections officials released Wednesday.

We might as well confront it head-on: What the Federal Reserve did this week doesn’t make any sense.

The Federal Open Market Committee on Wednesday cut the target range for the Fed funds rate by one-quarter percentage point, to 4.25% to 4.5%, its third consecutive rate reduction. Because the first, in September, was a “jumbo" half-percent cut, the central bank’s policy rate now has fallen a full percentage point from its post-pandemic peak.

This is remarkably dovish. Inflation remains well above the Fed’s 2% target. Also on Wednesday, central-bank officials conceded in their quarterly economic projections that inflation this year has been more stubborn than they had foreseen as recently as September.

Cutting rates despite all this is an even bigger head-scratcher than it first appears. Cast your memory back to December 2023, and another FOMC meeting and set of quarterly projections. Back then, Fed officials floated the possibility of rate cuts totaling three-quarters of a percentage point for this year, while assuming headline and core inflation (measured by the Fed’s preferred personal-consumption-expenditure index) both would be 2.4% by now and would be on track to reach 2% by 2026.

Chairman Jerome Powell was lauded in many quarters (including this column) for ditching those projected rate cuts in the spring after several months of data suggested inflation was lingering. We all spoke too soon. Since September, the Fed has cut rates further even than its December 2023 plan. This as core inflation exceeds the central bank’s prediction a year ago for where we’d be by now and as officials now think inflation won’t be whipped until 2027 instead of 2026.

To resolve this incongruence, the Fed on Wednesday attempted to transform its dovish policy action into a “hawkish cut" via flapping of the institutional jawbone. This is forward guidance: chattering about what the Fed will do in the future to manipulate the market today. The idea is that by talking to investors, the Fed can loosen or tighten financial conditions independent of any concrete action the FOMC takes.

Here, the goal was to tighten, or at least to loosen a bit less than the rate cut itself might suggest. In their runic dot plot of interest-rate predictions, officials signaled only two further rate cuts next year, compared with the four cuts officials had hinted in September. This is what triggered Wednesday’s sharp stock-market selloff—a sign that the officials succeeded in scaring investors straight.

But this is a blunt tool. The Fed is lucky markets stabilized Thursday instead of spiraling. And note how difficult it is to tell amid this divergence between Fed word (the dots) and deed (the rate cut) what the policy actually is.

At this point, we need a time-out. What does the Fed think it’s doing?

The Fed’s explanation for its moves is concern about softness in the labor market. Yet Mr. Powell, especially in his press conferences, has struggled to articulate what, exactly, worries officials these days. While some labor-market indicators (job creation, the quit rate) are softening, others remain strong (low unemployment, a low rate of layoffs).

Despite Mr. Powell’s insistence that monetary policy remains “restrictive," there isn’t much evidence this is so. Beyond ample anecdotal evidence from asset markets (and, indeed, sticky inflation), formal measures such as the Chicago Fed’s twin indexes of financial conditions have been loosening since March 2023. So it isn’t clear how monetary policy could be weighing on employment.

The Fed instead appears to be making an analytical error. Because the labor market is softer than in the immediate aftermath of the pandemic, and because the central bank thinks its policies act on inflation primarily by affecting employment, a softer job market must mean the Fed has made financial conditions tighter than before. This train of thought runs off the rails if something other than monetary policy influences the job market—tax policies, say, or regulation. But the Fed remains trapped in its dodgy economic models, which struggle to account for such things.

Therefore, so are the rest of us. An underappreciated fact of Wednesday’s equities plunge is that, in a different universe, markets would have been telling Mr. Powell all of this all along.

If the Fed hadn’t devoted so much energy to head-faking investors with forward guidance promising to do things the central bank shouldn’t do, those investors would have been warning the officials that inflation remains far from whipped. Were officials to yammer less at the markets, investors would be free to place meaningful bets about future inflation and send meaningful price signals about what the Fed should do in response. This is what long-bond investors, who increasingly seem to despair of forward guidance, have already done. They’ve pushed up yields since September in exasperated anticipation of inflation to come.

In the universe we actually inhabit, the Fed has chosen to try to chin-wag markets into submission. With the result that it’s hard to know exactly what the Fed is trying to do, let alone why.

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