Following the outcome of the September 2024 Federal Open Market Committee meeting, US monetary policy has been eased for the first time in four years. At a recent OMFIF discussion, Bill Dudley, former president of the Federal Reserve Bank of New York, analysed the Fed’s monetary policy trajectory amid these evolving economic dynamics.
In the discussion, chaired by OMFIF US Chair Mark Sobel, Dudley framed the recent 50-basis-point cut of the federal funds rate as a calculated move to secure a soft landing for the economy, including as a ‘catch-up’ after holding rates steady in July. Dudley praised Fed Chair Jerome Powell for uniting the committee behind the decision to cut by 50 rather than by 25 basis points, stating that the move was primarily driven by emerging signs of softening in the labour market.
Looking towards 2025, Dudley speculated that the federal funds rate could stabilise around 3-3.5%, provided labour market conditions do not deteriorate. Current market pricing reflects two potential scenarios, both relatively benign: either no recession, leading to neutral rates, or a mild recession prompting the Fed toward easier monetary policy. Dudley emphasised the importance of pre-emptive action, pointing out past instances where the Fed was slow to respond to signs of economic overheating.
Divergence of inflation and employment
The Fed’s dual mandate – achieving price stability and maximum employment – requires careful balancing as inflation and employment diverge. While the FOMC’s focus has been on inflation over the past two years, Dudley noted that core inflation is trending downwards, now around 2.5%, edging closer to the Fed’s 2% target. At the same time, labour market softness is becoming evident, with the unfilled jobs-to-unemployment ratio dropping from 2:1 to 1:1.
He warned that rising unemployment could trigger recessionary pressures and noted that close monitoring of labour market indicators will be crucial. Although unemployment has risen, Powell views this as driven by increased labour force participation rather than widespread layoffs. This, in combination with gross domestic product holding up well, suggests that recession risks remain low. But when it comes to future rate decisions, Dudley reflected, ‘I think the labour markets now are going to get 80% of the attention and inflation 20% – six months ago, it was reversed.’
The 50-basis-point cut serves as a buffer against further weakening in the labour market. In the absence of a recession, Dudley projected that the federal funds rate may hover between 3% and 3.5%, but in a more severe downturn, they could fall even further, to somewhere between 2-3%.
Inflation persistence and investor optimism
Several risks complicate the monetary policy outlook. Inflation, particularly in service sectors, remains sticky, with prices above 4%. During the discussion, Dreyfus Chief Economist and former FOMC monetary policy director Vincent Reinhart raised concerns that inflation may persist longer than expected, complicating the Fed’s efforts. Rising goods prices also present upside risks to inflation forecasts.
‘The world’s a risky place, and a part of the disinflation in 2024 has been the fact that goods prices have basically been unchanged,’ explained Reinhart. ‘I’m not sure that we should count on that over the next year… I have an upside risk associated with that.’
Market optimism also poses a challenge. Speakers agreed that investors anticipating rapid shifts to accommodative policies may underestimate the risks associated with rising interest rates. Effective communication with the market is therefore critical for the Fed going forward.
During the discussion, Sonal Desai, chief investment officer for Franklin Templeton Fixed Income and former International Monetary Fund economist, pointed out a disconnect between tight high-yield debt spreads and underlying economic recession fears. While spreads indicate market optimism, the Fed must avoid exacerbating risks by mismanaging expectations. Dudley noted that markets are ‘still pretty aggressive in the near term’. But he echoed Desai’s concerns regarding excessive optimism – if markets ‘expect more than Powell can deliver’, it could destabilise financial conditions, complicating the Fed’s management of rate expectations.
Quantitative easing, tightening and R* important factors in framework review
Dudley voiced modest expectations for the upcoming Fed monetary policy framework review. A thorough review of its quantitative easing and quantitative tightening practices was noted as essential by all discussants as well as a more pre-emptive symmetrical approach to inflation under- and overshoots. Dudley criticised the lack of a structured framework for assessing these tools, noting a $200bn deficit in the Fed’s balance sheet. There is a growing consensus that QE should not be the Fed’s first tool in future downturns; instead, conventional tools should be prioritised.
The equilibrium real interest rate, or R*, remains uncertain. Dudley agreed with Powell’s assessment that R* is likely higher than during the 2008 financial crisis, especially given fiscal pressures, and noted that Fed policy-makers’ estimations range between 2.4% and 3.8%. More generally, he lamented the lack of focus in the US on fiscal debts and deficits, observing that these could boost the term premium and even raise questions about fiscal dominance.
The Fed’s ability to balance inflation control with labour market stability is crucial as it navigates fiscal policy uncertainties, market dynamics and economic risks. The path ahead will require a pre-emptive yet cautious stance and effective communication, along with clearer plans for QE and QT and more clarity on R*.
Yara Aziz is Economist and Taylor Pearce is Lead Economist, Economic and Monetary Policy Institute at OMFIF.
