Rate Cuts May Be on the Way, But Should They Be?
New Policy Brief on the Interaction of Fiscal and Monetary Policies
Yesterday the Mercatus Center published my policy brief entitled “Why the Fed Moves Slowly on Inflation and Rates.” My intent was to show the following:
Since 2020, monetary policy has been driven by fiscal policies. This is what economists refer to as fiscal dominance.
The inflation that arose during 2021 was the culmination of all fiscal and monetary policies beginning in 2020—not just the American Rescue Plan.
Efforts to strong-arm the Fed into lower interest rates are misguided and will likely lead to the unintended outcomes of higher interest rates and higher inflation.
I think this third point is worth emphasizing here.
The primary interest rate the Fed targets is known as the federal funds rate (FFR). As the St. Louis Fed describes it, the FFR “is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.” In short, it’s a centrally determined short-term interest rate.
Uncoincidentally, other short-term rates closely follow the FFR as it sets a sort of “minimum return” for financial institutions. Longer-term rates, however, follow the FFR less closely. Consider figure 7 from the brief.
I highlight two time periods in figure 7. The first is from mid-2020 through early 2022. In early 2020, at the beginning of the COVID-19 pandemic, the 10-year Treasury yield plummeted due to a combination of rate cuts and widespread economic uncertainty. However, the 10-year yield steadily rose through early 2022 without a single rate hike. This happened both because the economy recovered much faster than expected and because inflation expectations were on the rise.
The second period I highlight is September 2024, when the Fed started cutting rates, beginning with its surprise 0.5-percentage-point rate cut. Rather than fall with the rate cuts, the 10-year Treasury yield rose over the next four months by a total of 1.2 percentage points, despite a cumulative 1.0-percentage-point reduction in the FFR over the same period. Another expected increase in inflation coincided with this period—suggesting that the bond market believed the Fed cut rates too soon.
Now, what do those examples mean for policymakers? We should be asking ourselves, “If long-term yields jumped after those unprovoked rate cuts, how would the market react to rate cuts now, given the current pressure the Fed is facing?” The primary concern is that a rate cut would be interpreted by the bond market as a return to the accommodative monetary policies that preempted the inflationary surge. As a result, the bond market would demand higher interest rates today in anticipation of higher inflation tomorrow.
Maybe this concern is overblown, but it’s a question worth asking ahead of the Fed’s interest rate announcement next week and in light of what occurred the last time the Fed cut rates.
However, the two major employment reports from the Bureau of Labor Statistics this past week have muddied the waters a bit with recession fears. This may have given the Fed just enough wiggle room to cut rates and appease the administration without distressing the bond market. Or the alternatively, the Fed may dig in its heels and maintain rates in another effort to show it won’t cave to political pressure.