Fed Chair Jerome Powell announces key interest rate decision

Key Concepts

• Dual Mandate: The Federal Reserve's objectives of achieving maximum employment and stable prices.
• Federal Funds Rate: The target interest rate set by the Federal Open Market Committee (FOMC) for overnight lending between banks.
• Monetary Policy: Actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.
• Quantitative Tightening (QT): The process of reducing the size of the Federal Reserve's balance sheet by allowing assets to mature without reinvesting the proceeds.
• Neutral Rate: The theoretical interest rate that neither stimulates nor restrains economic growth.
• PCE Inflation: Personal Consumption Expenditures inflation, a key measure of inflation used by the Federal Reserve.
• Core PCE Inflation: PCE inflation excluding volatile food and energy prices.
• Labor Force Participation Rate: The percentage of the working-age population that is either employed or actively seeking employment.
• K-Shaped Economy: An economy characterized by a divergence in economic performance, with higher-income individuals and sectors experiencing growth while lower-income individuals and sectors struggle.
• AI Infrastructure: Investments in technology and facilities, such as data centers, that support the development and deployment of artificial intelligence.

Monetary Policy Decisions and Economic Outlook

The Federal Open Market Committee (FOMC) has decided to lower its policy interest rate by a quarter percentage point, bringing the target range for the federal funds rate to 3.75% to 4%. This decision is driven by the FOMC's commitment to its dual mandate of maximum employment and stable prices.

Key Economic Observations:

• Economic Activity: Available indicators suggest that economic activity has been expanding at a moderate pace. GDP rose at a 1.6% pace in the first half of the year, a slowdown from 2.4% last year. Stronger consumer spending has contributed to a potentially firmer growth trajectory than initially expected. Business investment in equipment and intangibles has continued to expand, while the housing sector remains weak. The federal government shutdown is expected to weigh on economic activity temporarily, with effects reversing after its conclusion.
• Labor Market: The unemployment rate remained relatively low through August. Job gains have slowed significantly since earlier in the year, partly due to a decline in labor force growth from lower immigration and participation, as well as a softening in labor demand. While official September employment data is delayed, available evidence indicates low layoffs and hiring, with declining perceptions of job availability and hiring difficulty. Downside risks to employment have risen.
• Inflation: Inflation has eased significantly from its mid-2022 highs but remains elevated relative to the 2% long-run goal. Total PCE prices rose 2.8% over the 12 months ending in September, and core PCE prices also rose 2.8%. Inflation for goods has picked up, largely due to tariffs, while disinflation appears to be continuing for services. Near-term inflation expectations have moved up, influenced by news about tariffs, but longer-term expectations remain consistent with the 2% goal.

Rationale for Policy Actions

Interest Rate Reduction:

• The decision to lower the policy interest rate is in support of the FOMC's dual mandate goals and in light of the balance of risks to employment and inflation.
• With downside risks to employment having increased, the balance of risks has shifted, prompting a move towards a more neutral policy stance.
• The FOMC aims to ensure that a one-time increase in the price level due to tariffs does not become an ongoing inflation problem.

Conclusion of Securities Holdings Reduction (Quantitative Tightening):

• The FOMC decided to conclude the reduction of its aggregate securities holdings as of December 1.
• This decision is based on signs that reserves are now somewhat above the level judged consistent with ample reserve conditions.
• Evidence includes upward movement in repo rates relative to administered rates, increased pressures on selected dates, and more use of the standing repo facility.
• The effective federal funds rate has also begun to move up relative to the rate of interest on reserve balances.
• Over the past three and a half years, securities holdings have declined by $2.2 trillion, and the balance sheet as a share of nominal GDP has fallen from 35% to about 21%.
• In December, the balance sheet size will be frozen, with agency securities run off and reinvested in Treasury bills to move towards a portfolio primarily of Treasury securities and shorten the weighted average maturity.

Discussion on Future Policy and Risks

December Meeting and Policy Path:

• The possibility of a further reduction in the policy rate at the December meeting is not a foregone conclusion. Policy is not on a preset course.
• There were strongly differing views among FOMC participants regarding how to proceed in December, reflecting different forecasts, risk aversion levels, and assessments of the economic outlook.
• The committee will continue to determine the appropriate stance of monetary policy based on incoming data, the evolving outlook, and the balance of risks.
• The current situation presents a tension between the dual mandate, with upside risks to inflation and downside risks to employment, making policy decisions challenging.

Impact of Tariffs:

• Higher tariffs are pushing up prices in some goods categories, contributing to higher overall inflation.
• The base case is that these effects will be relatively short-lived, representing a one-time shift in the price level.
• However, there is a risk that these effects could be more persistent, and the FOMC is focused on ensuring this does not become an ongoing inflation problem.
• Inflation away from tariffs is estimated to be closer to the 2% goal, potentially around 2.3% or 2.4% for core PCE excluding tariffs.

Labor Market Weakness and Policy Response:

• The weakening in the job market is attributed to a dramatic reduction in the supply of new workers (declining labor force participation and immigration) and a decline in labor demand.
• The rate cut is intended to support demand and help prevent further deterioration in the labor market.
• While some argue that labor market issues are primarily supply-driven and beyond the Fed's tools, others, including the Chair, believe that demand support from monetary policy can have an effect.
• The Fed does not see the weakness in the job market as accelerating, with initial claims and job openings data remaining relatively stable. However, large companies are announcing layoffs or reduced hiring, often citing AI.

Data Drought due to Government Shutdown:

• The shutdown of the federal government has delayed important economic data, creating a "data drought."
• This situation makes it more difficult to assess the state of the labor market and make policy decisions.
• The FOMC will rely on available private sector data, surveys, and the Beige Book, but acknowledges that this does not replace government data.
• In the absence of clear data, there is a possibility of proceeding with added caution, akin to "driving in the fog" by slowing down.

AI Investment and Market Bubbles:

• Significant investment in AI infrastructure, such as data centers, is occurring.
• This spending is generally considered less interest-sensitive and driven by longer-run assessments of productivity gains.
• The Fed does not believe that current interest rate levels are a primary driver of AI-related investment or that rate cuts are likely to fuel market bubbles in this sector.
• The AI boom is seen as a significant source of economic growth, but consumer spending remains a larger component of the economy.
• Unlike the dot-com bubble of the 1990s, current tech companies have earnings and business models, making them different from purely speculative ventures.

Financial System Stability and Loan Losses:

• The Fed is closely monitoring credit conditions and rising defaults in subprime auto loans.
• While some financial institutions are experiencing losses, the Fed does not currently see a broader credit issue posing systemic risk.
• Banks are generally well-capitalized, and aggregate household finances are relatively manageable, though lower-income households are under stress.

K-Shaped Economy and Consumer Spending:

• The economy is described as bifurcated, with higher-income individuals continuing to spend while lower-income individuals are pulling back and shifting to lower-cost products.
• The stock market's strength is a factor supporting consumption, particularly for wealthier individuals, but the marginal propensity to consume declines with increased wealth.
• A sharp correction in the stock market could impact spending, but it is not expected to cause a dollar-for-dollar drop in consumption.
• Consumers at the lower end of the income and wealth spectrum have a higher marginal propensity to consume but lack significant stock market wealth.

Notable Quotes

• "My colleagues and I remain squarely focused on achieving our dual mandate goals of maximum employment and stable prices for the benefit of the American people." - Chair Powell
• "Although some important federal government data have been delayed due to the shutdown, the public and private sector data that have remained available suggest that the outlook for employment and inflation has not changed much since our meeting in September." - Chair Powell
• "A further reduction in the policy rate at the December meeting is not a foregone conclusion. Far from it." - Chair Powell
• "We continue to face two-sided risks." - Chair Powell
• "There is no risk-free path for policy as we navigate this tension between our employment and inflation goals." - Chair Powell
• "If you're driving in the fog, you slow down." - Chair Powell, on policy in the face of data uncertainty.
• "When you see one cockroach, there may be more likely." - Jamie Dimon (JPMorgan CEO), quoted by Jennifer Shon Burgerer, on loan losses.

Conclusion

The FOMC has implemented a quarter-percentage-point rate cut and concluded its balance sheet reduction program, signaling a shift towards a more neutral policy stance. This decision reflects a careful balancing of risks, with increased downside risks to employment and upside risks to inflation. The committee emphasizes that future policy decisions will be data-dependent and that the path forward is not predetermined, particularly regarding potential rate cuts in December. The ongoing government shutdown and the resulting data drought add a layer of uncertainty, potentially leading to a more cautious approach. The FOMC remains committed to its dual mandate and will continue to monitor economic developments closely to achieve its goals of maximum employment and stable prices.