The Federal Reserve's Costly Cut

Gabriel Russ-Nachamie: Rate cuts now undermine price stability and weaken the Fed’s long-term credibility.

Last Wednesday, the Federal Reserve lowered its target for the federal funds rate and signaled it would continue easing policy at upcoming Federal Open Market Committee meetings. This came after weaker-than-expected labor market data and pressure from President Trump for lower rates. But the decision was a mistake. By loosening policy now, the Fed risks undermining its fight against inflation and weakening its credibility.

First, it’s important to note that the weakness in the labor market likely reflects a real shock to the labor market, rather than a nominal shock to the economy. Instead of a nominal or demand shock to the economy that lowers total spending, which usually occurs during a recession, such as through lower investment or consumer spending, the economy’s capacity to turn inputs into outputs has been constrained. In such cases, the Federal Reserve's tools are limited. According to the Federal Reserve Bank of St. Louis, the weakening labor market stems from more people entering the forceforce but struggling to obtain employment, as well as fewer unemployed workers being able to find jobs. Additionally, the president's restrictive immigration crackdown and tariffs have likely harmed the labor market by acting as a negative supply shock to the economy.

If weakening employment numbers reflect a real negative shock to the economy, the Fed must choose between an expansionary monetary policy that prevents output from falling or a contractionary policy that stops inflation from rising. It appears the Fed has chosen to loosen policy in response to supply-side conditions to achieve its congressional mandate of not only achieving stable prices, but also maximum employment. While this strategy might work in the short term, the Fed risks undermining price stability by loosening monetary policy.

This expansionary policy harms its goal of maximum employment because a stable labor market requires stable prices to transmit economic information. Additionally, if inflation exceeds its target, the Fed will have to tighten monetary policy, which risks harming the labor market.

Besides the labor market, there are no signs that the US economy is heading towards a recession that would require significant monetary accommodation. GDP grew at a seasonal and inflation-adjusted annual rate of 3.3% in the second quarter, indicating a strong economy with little evidence of the need for monetary stimulus. Furthermore, the Federal Reserve Bank of Atlanta's GDPNow forecast projects a robust 3.5 percent growth rate of Real GDP in the third quarter.

The strongest argument against cutting rates further at this time is the risk of exacerbating inflationary pressures. Inflation remains elevated above the Fed's 2% target. Core CPI was 3.1 percent over the last 12 months in August, and the Producer Price Index had its largest monthly increase since June 2022. The core personal consumption expenditures price index (Core PCE), which measures the inflation the Fed targets at 2%, showed that inflation increased at a seasonally adjusted annual rate of 2.9% in July.

Instead of turning to the Federal Reserve to solve our current labor market problems, the American public should look to President Trump and Congress. For example, President Trump could announce a more predictable trade policy and limit tariffs on goods deemed necessary for national security. President Trump’s tariffs have acted as a negative supply shock to the economy as they increase the relative costs of imported goods. The higher price of imported goods reduces the economy's output, as the increased cost of inputs raises the cost of production. When American consumers and businesses spend more on imported goods, they also have less money to spend on other parts of the economy, resulting in lower overall output. A 2019 paper in the Journal of Economic Perspectives finds that the tariffs Trump implemented in his first term, “were almost completely passed through into US domestic prices in 2018,” hurting American consumers the most. Moreover, reversing immigration policies that reduced the U.S. workforce could ease labor market strains while boosting economic growth and helping contain inflation.