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In times of uncertainty, central bankers have often invoked the “Brainard conservatism principle”. Coined by economist William Brainard in 1967, it recommends that when monetary policymakers are unsure of the effects of their interest rate policies, they ought to react by less than they would with greater certainty. As the US Federal Reserve discusses whether to initiate the rate-cutting cycle with a reduction of 25 or 50 basis points at its meeting this week, the principle would appear to give a clear answer.
But caution is less relevant when the balance of risks to the Fed’s dual mandate — to achieve 2 per cent inflation, and support employment — are uneven. That may now be the case. The August consumer price index data showed annual price growth falling to just 2.5 per cent, in line with the Fed’s preferred PCE measure. The jobs market, however, is cooling rapidly. Non-farm payroll numbers have been revised down over the summer, the jobs opening rate is back near pre-pandemic levels and small business hiring plans are subdued.
Put simply, the risk of over-constraining the American jobs market seems to be greater than the risk of US inflationary pressures reviving again. High rates are sapping demand, and while significant lay-offs have not occurred yet, they often spiral when they do arise as rising unemployment tends to feed off itself. It makes sense to guard against this outcome, by making a substantive rate cut, particularly given the space the Fed has on the inflation side of its mandate. Indeed, even as rates fall, some households and businesses that had locked in low rates during the pandemic may experience a tightening as they refinance.
Advocates for a 25bp cut argue that the inflation battle is not yet won. It is true that services inflation remains high. But a significant proportion of that comes from shelter costs, which include components that lag above actual market prices. Excluding shelter, CPI inflation is below 2 per cent. Wage growth, a key price pressure, is also tame. Elevated pay growth in the UK, by contrast, is one reason why the Bank of England — which has already made its first cut — may hold fire when it meets on Thursday.
Recent shifts in futures pricing have also improved the case for a heftier cut. For a few weeks, investors were mostly expecting a 25bp cut in September, but market bets for a 50bp cut rose on Friday, following comments by former Fed officials reported in the Financial Times. This has lowered the risk of surprising the market on Wednesday and stirring a frantic sell-off. (Indeed, over the summer, traders demonstrated their jitteriness over even slight misses in their expectations.) If expectations for a larger cut do not recede notably by midweek, a 50bp cut would be easier to communicate. A clear and calming tone from the Fed, in any case, would be needed.
But, if Powell does play it cautiously, with 25bp, there is a greater onus on him to flesh out the central bank’s subsequent rate-cutting plans. A dovish tone that emphasises the need for cuts in the final quarter, outlines the path beyond, and mentions the Fed’s willingness to make chunkier cuts if needed, could help send the right signal to markets.
The US election, which is a day before the Fed’s next meeting in November, obscures the economic outlook somewhat. Powell can only act on what he knows now, and is right to ignore politics — including threats from Donald Trump over the Fed’s independence.
Central banking is an inexact science. Yes, uncertainty warrants caution, but it also means taking out the right insurance when possible. A 50bp cut this week safeguards against overly restricting the economy and adverse market reactions to any weak data releases before its next meeting. Providing investors remain open to a bigger cut, invoking Brainard’s principle this time around feels less justifiable.
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