Inflation remains stubbornly above the Federal Reserve’s 2 percent target. Yet, instead of maintaining a firm stance at its December 18 meeting, the Fed cut interest rates for the third time in three months. The Fed should move slowly going forward and look for stronger evidence that post-pandemic inflation has run its course before continuing with cuts.
The costs of prematurely stopping the anti-inflation campaign are clear. Inflation cuts real wages for workers and erodes the real value of savings. It distorts markets by redistributing wealth and raising uncertainty about investment in the future. Left unchecked, it could erode trust in the monetary system, just as trust in American institutions is falling.
Multiple measures track inflation. The consumer price index (CPI), the most closely watched by the public, grew 2.7 percent over the 12 months that ended in November. The Fed’s preferred measure, the Personal Consumption Expenditures Price Index, grew 2.3 percent over the 12 months ending in October.
Other measures of trend inflation are even more elevated. Core CPI, which discards volatile food and energy prices, rose 3.3 percent over the preceding year. Median CPI, which gives an indication of the trend in inflation by ignoring extreme changes, went up 3.9 percent over the previous year, and has been above CPI growth for the past two years. Similarly, the Atlanta Fed’s Sticky-Price CPI, which highlights prices that are slow to change, increased 3.8 percent over the past year.
Rents are a major remaining driver of inflation. The pandemic led many Americans to reconsider where they live. Interestingly, more than 13 million Americans have moved from progressive states to conservative ones, according to IRS data compiled by the American Enterprise Institute. The rental market moves more slowly than other markets, so it may take a while for it to adjust fully to the Covid shock.
Altogether, the inflation data show an inflation rate that remains high and will take some time to come down. But maintaining stable prices isn’t the Fed’s only goal; it’s also tasked with ensuring full employment. The unemployment rate is 4.2, still 0.2 percent below the non-cyclical rate of unemployment, which is the rate consistent with stable prices. Correspondingly, real GDP is still above potential GDP (the level of output consistent with stable inflation). This output gap has only widened since 2022.
The Fed is often caught between trying to balance stable prices and full employment. A predetermined policy rule can help it manage this balance without over- or under-reacting to data. One popular policy rule, named for economist John Taylor, adjusts the federal funds rate based on inflation and the output gap.
Two different versions of the Taylor Rule suggest that the federal funds rate should be higher than it is currently. While the federal funds target after Wednesday’s meeting is 4 to 4.5 percent, the classic Taylor Rule, and a modified version proposed by former Fed Chairman Ben Bernanke, suggest rates around 6 percent to 7.75 percent.
Had the Fed followed the prescriptions of the Taylor Rule during and after the pandemic, it might not have missed the coming inflation in the first place. In 2021, the Taylor rule jumped along with inflation, but the Fed waited to start tightening until later in 2022.
Though the data show that inflation and output are high, a case can be made for lower rates. The Fed wants to settle rates at a neutral level that neither fuels inflation nor crashes the economy, referred to as r-star. R-star is not observable; it has to be estimated from economic data. Two estimates of r-star from the New York Fed suggest that a neutral rate would be much lower, around 0.75–1.25 percent. Those estimates have also been falling since the start of 2022. If the neutral rate is falling, then falling rates are consistent with inflation mitigation.
This Fed meeting also included an updated Summary of Economic Projections, which shows how committee members reacted to this quarter’s economic data and how they anticipate future data. They raised projections for inflation through 2026, slightly raised projections for GDP this year and next, and slightly lowered projections for unemployment this year and next. Correspondingly, they anticipated tightening future policy, with projections for the federal funds rate being about 0.5 percent higher through 2026.
It’s reasonable to infer from the output and employment data that we’re nearing a turning point in the business cycle. But that suggests thinking of Fed cuts as easing off the brakes rather than hitting the gas. If the Fed maintains this framing over the next year and stays the course until inflation is back at 2 percent, it could still achieve the hoped-for soft landing.
Congress could help the Fed achieve a soft landing by searching for some fiscal discipline in the next budget. The Congressional Budget Office projects the federal deficit to run between 5.5 and 7.1 percent of GDP over the next decade, compared with an average deficit of 2.1 percent between 1947–2019.
The expiration of key provisions of the Tax Cuts and Jobs Act will provide an opportunity to revisit revenue and spending levels. Lower tax rates may spur growth, but high and rising federal debt will act as a drag on it. The new Department of Government Efficiency can also help identify spending cuts. A smaller federal deficit will help the Fed bring down rates and support growth without stoking more inflation.
Meantime, the Fed will review its framework and long-term policy objectives next year. The last framework, released in August 2020, saw the agency adopt an asymmetric inflation target, which would make up for periods of low inflation by allowing periods of high inflation. The intervening cycle of inflation and disinflation offers lessons for the next review. The Fed should consider adopting a symmetric target and incorporating something like the Taylor Rule as an anchor for policy.
In 2025, the Federal Reserve should remain focused on inflation. Cutting rates prematurely or too quickly risks sending the wrong signals about its commitment to securing stable price levels.
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