Fed at a Crossroads: Is There a Case for Cutting Interest Rates
Former JPMorgan Chase Global Chief Economist (Ph.D. in Economics) & Current Global Keynote Speaker
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Federal Reserve Chair Jerome Powell finds himself in a familiar yet uncomfortable position, facing intense political pressure to cut rates by as much as 200 basis points. As the economy grapples with inflation expectations that remain sharply above the growth target, the question arises: Can the Federal Reserve justify such a dramatic rate cut based on economic fundamentals?
The Case for Rate Cuts
The Federal Reserve Chair is under increasing pressure to adopt a more accommodating monetary policy, with demands for a 200-basis-point cut to support economic growth, lower long-term interest rates for hardworking middle-class Americans, and lower the cost of financing our $36.2 trillion national debt!
Yet, we must not forget that in 2024, when the Federal Reserve cut interest rates, long-term interest rates moved higher. After the Fed cut rates by 100 basis points in 2024, the 10-year Treasury yield rose by 100 basis points by mid-January 2025 as credit markets concluded that the rate cuts were ill-advised! If U.S. credit markets were correct, why would we want to pile on an additional 200 basis points of cuts all at once?
We would also be remiss if we overlooked that the latest University of Michigan survey of consumers revealed they expect consumer prices to rise by 6.6% over the next 12 months, up from a prior reading of 6.5% while the Conference Board survey of U.S. consumers expects inflation to increase by 6.5% over the next 12 months, down from a reading of 7.0% the prior month. In contrast, another survey of consumers conducted by the New York Federal Reserve generated a more optimistic outlook with consumers expecting inflation to rise by only 3.2% over the next 12 months, down from a prior reading of 3.6%! All these surveys expect inflation to increase more over the next year than the Fed’s 2.0% inflation growth target!
Given such evidence, a 2% rate cut in a world where the Fed is mandated to keep inflation at or near a 2.0% growth rate seems extreme, even when measured against traditional monetary policy frameworks. One of them is the Taylor Rule—a widely respected model that estimates the “appropriate” level of the federal funds rate based on inflation and economic output.
The Original Taylor Rule
The original Taylor Rule sets the federal funds rate based on three variables: the neutral real interest rate (assumed to be 2.0%), the deviation of actual inflation from the target, and the output gap (how far real GDP is from potential GDP). With core CPI currently running at 2.8% and assuming full employment, the formula implies a federal funds rate of approximately 4.8%. Given that the current federal funds rate stands at 4.33%, the Taylor Rule—using traditional assumptions—would not support a rate cut, let alone a 200-basis-point reduction.
Source: Brookings Institution, and St. Louis Federal Reserve
Updated Neutral Rate Offers Some Good News
However, there’s a growing consensus among economists, including some at the Federal Reserve, that the “neutral” real rate—the level at which monetary policy is neither stimulating nor restraining the economy—has declined. Research by the Federal Reserve Bank of New York’s President John Williams, (whose Dissertation Advisor was the author of the Taylor Rule) along with a study by the Brookings Institution, estimates the neutral rate to be somewhere between 0.5% and 1.0%, rather than the original 2.0% used in the Taylor Rule.
If we update the Taylor Rule with a neutral rate of 0.5% to 1.0%, the implied federal funds rate decreases to a range of 3.3% to 3.8%—a range that is below the current 4.33%, providing at least some theoretical support for the idea of a modest reduction by the Federal Reserve.
Source: Brookings Institution, and St. Louis Federal Reserve
Real Interest Rates: A Restrictive Stance
One way to measure whether interest rates are restrictive is by calculating the real federal funds rate, which is the nominal federal funds rate minus the inflation rate. Based on the current core CPI (which excludes food and energy) of 2.8%, the real rate is approximately 1.5%. If we use the yearly growth rate in the headline CPI, the real rate is about 2.0%.
For context, during the Paul Volcker-led war on inflation in the 1980s, the Fed kept real rates near or above 3% to battle high inflation. Historical data from 1958 to the present indicate that real rates above 1% are typically associated with restrictive policy stances aimed at moving inflation closer to its 2.0% target.
History also reveals that the Fed typically doesn't cut rates unless inflation is falling decisively and the economy faces growing risks, such as unemployment or recession. Despite signs of disinflation, inflation remains above the Fed’s 2% target, and the labor market, though softening, remains relatively strong by historical standards.
The Fed’s Credibility
Another reason the Fed remains reluctant to embrace an immediate rate cut—even with a real rate above 1.5%—is its tarnished credibility from the pandemic era. In 2021 and early 2022, the central bank was slow to react to rising inflation, holding on to the “transitory” narrative far too long. This policy error contributed to inflation peaking at over 9%, severely damaging the Fed’s reputation.
To restore its inflation-fighting credibility, the Fed has since adopted a more cautious posture. That means it is unlikely to respond quickly to political pressure or ease unless there’s unmistakable evidence that inflation is returning to its target.
Political Pressure vs. Economic Reality
Individuals facing high borrowing costs on credit cards, auto loans, and mortgages would greatly welcome lower interest rates. However, justifying a 2.0% rate cut economically would be challenging. This reduction would lower the federal funds rate to 2.3%—significantly below the current inflation rate—resulting in a negative real interest rate.
That kind of policy would be expansionary, not neutral. Unless the U.S. economy falls into recession or inflation dips sharply below target, this would be inconsistent with the Fed’s mandate to maintain price stability.
Data from the past 65 years suggest the Fed generally maintains or even raises interest rates when inflation is above target—unless the economy faces clear signs of contraction, such as rising unemployment or falling GDP. Currently, the well-respected Atlanta Fed GDP Nowcast model is projecting 3.8% real GDP growth for the second quarter of 2025.
A Possible Path Forward
Still, there may be some room for policy recalibration. If the core PCE inflation rate continues to drift lower—say, toward 2.4% or below—and labor market conditions deteriorate further, the Fed could justifiably lower rates by 25 to 50 basis points later in 2025. This would bring the policy rate closer in line with revised estimates of the neutral rate, while still maintaining favorable real rates, as inflation would remain above its target growth rate.
Moreover, if future revisions show the economy was weaker than currently understood—say, due to a decline in consumer spending or a worsening credit crunch—the Fed could act more aggressively. But for now, the bar for a cut remains high.
Summary and Concluding Thoughts
While White House pressure for a 200-basis-point cut is unlikely to influence the Fed’s policy rate decision at its June 17-18, 2025, policy meeting, it has reignited debate about whether rates are too restrictive.
With inflation still running above the 2% target and Fed officials wary of repeating past mistakes, the central bank is likely to stay on hold. It appears that the Fed will wait until core inflation moves closer to its inflation target or sees evidence of rising economic risks before abandoning its cautious stance. With the Atlanta Fed nowcast GDP model projecting 3.8% in Q2 2025, it is hard to imagine that the U.S. economy is teetering on the brink of an economic collapse.
In short, while Fed Chair Powell may not be ready to “pivot” next week, using the modernized Taylor Rule can offer some justification for modest easing if core inflation continues to move lower over the next month or two.
As always, we keep an open mind and invite the reader to decide whether the Federal Reserve should lower interest rates next week, or wait another month or so, to cut rates.