Should the US Federal Reserve keep cutting interest rates? Markets certainly think it will: Futures prices suggest the federal funds rate will fall to about 3% by the end of 2026, from just above 4% now.
I’m not so sure that would be a good idea.
The arguments for cutting rates fall into three buckets.
1) Risk management. Chair Jerome Powell has made this case, saying that the upside risk to inflation no longer outweighs the downside risk to the labor market, with job growth slowing sharply and the price impact of tariffs likely to be temporary. It assumes that monetary policy is “moderately restrictive,” and hence should move towards a more neutral stance. This is reflected in Fed policymakers’ near-unanimous decision to cut interest rates last month — even as they raised their median growth and inflation forecasts.
I’m not convinced. Inflation might still be the greater risk. The Fed has exceeded its 2% inflation target for more than 4.5 years and is missing that target by a greater margin than its employment objective. The pass-through of tariffs into prices, while slower and less substantial than expected, is far from over. And monetary policy might not actually be all that restrictive: Recent economic data indicate that demand has strengthened, with the Atlanta Fed GDP Now model forecasting 3.8% annualized growth in the third quarter.
2) Anticipation. As Governor Michelle Bowman argued in a recent speech, if the Fed waits for data to confirm a further deterioration in the labor market, it might be too late. So the Fed must act preemptively.
I agree that policy should be preemptive — but only if one has adequate confidence in one’s forecast. Right now, the economic outlook is highly uncertain: It’s impossible to know whether to worry more about inflation becoming entrenched and inflation expectations less well-anchored, or about the labor market deteriorating substantially. So there’s a significant risk that preemptive action will prove to be a costly mistake.
3) Estimation error. By this logic, which Fed governor Stephen Miran has espoused, monetary policy is actually much tighter than the Fed thinks, because the neutral interest rate — the rate that neither damps nor stimulates growth — has fallen considerably. Among the reasons Miran has cited to believe this: Slowing population growth will reduce the demand for capital to equip and house people, tariff revenue will reduce government borrowing, and tax cuts will increase national saving.
