This week, the Fed’s monetary policy committee will almost certainly cut its policy interest rate, the “fed funds rate.” That initial loosening of monetary policy will be a welcome development, even if only a 0.25 percent cut. But a larger reduction, of 0.5 percent, would be even more welcome.

Although inflation has been moving downward for a couple of years now, this rate cut has been a long time in coming. That’s partly because markets and the Fed have occasionally been wrong-footed by data surprises, especially the uptick in inflation in the first quarter of this year. And it’s partly because the US economy has been surprisingly resilient in the face of the highest interest rates in a couple of decades. But it’s also because the Fed has been exceptionally cautious in taking its foot off the brakes. 

When inflation hit nine percent in mid-2022, Fed policymakers faced a deeply asymmetric challenge: A moderate recession would be viewed as a worthwhile price to pay for getting inflation back under control, but continued high inflation à la 1970s would put Fed Chair Jay Powell’s portrait up there with Arthur Burns in the rogue’s gallery of failed central bankers. In consequence, the Fed has sought nearly iron-clad assurance that any monetary loosening will not be premature and trigger a reversal of disinflationary progress toward its two percent target.

It now looks like that assurance is forthcoming.  As Fed Chair Powell emphasized in his recent Jackson Hole speech, inflation has fallen below three percent, wage gains have slowed, and the labor market is coming into balance. As a result, he all but promised there would be a rate cut at the Federal Open Market Committee’s September meeting. 

Fed officials initially signaled that this rate cut would likely be the standard 0.25 percent. This modest adjustment is in line with the practice of most central banks to follow “interest rate smoothing”—that is, make only small changes in interest rates in order to avoid having to reverse these changes if they prove premature. And such caution is understandable in light of the blow to the Fed’s reputation that would occur were the downward trend in inflation to reverse course.

Nevertheless, a larger, 0.5 percent cut in the Fed funds rate would be better. And, indeed, some recent articles by Fed-watching journalists suggest that might be in play. To begin with, the economy no longer appears to be overheating. At 4.2 percent, the unemployment rate is exactly in line with the rate believed by the Fed to represent balance in the labor market, and job growth has declined substantially. And not only has inflation come down substantially, but remaining price pressures as measured in the August Consumer Price Index report appear to exclusively reflect rising housing costs—more timely data on rents from private sources suggest these pressures will be subsiding. 

If the economy is close to balance and inflation likely to decline further, then interest rates should also be at normal levels. Economists refer to these as “neutral” rates, which means “the short-term interest rate that would prevail when the economy is at full employment and stable inflation.” Neutral interest rates cannot be directly observed, but reasonable estimates would center around three percent: two percent to compensate investors for inflation and an additional one percent to reflect real returns to capital. In fact, in the projections last released in June, Fed officials put that rate at 2.8 percent.

So, with inflation largely contained and the economy essentially in balance, interest rates should be closer to three percent than five percent. And even if there is greater strength in the economy than most economists judge, or if neutral interest rates are higher, there is still a very sizeable cushion between where interest rates are and where they need to be. This means that even a 0.5 percent rate cut can be made with little risk of re-igniting inflation. 

Finally, it bears noting that the Fed is not alone in this process. Other central banks are also grappling with how quickly to loosen policy as inflation declines. But the Fed is among the relatively few that have yet to lower policy interest rates. In fact, my research shows that, measured by the response of interest rates to the run-up in inflation, the Fed has become one of the world’s most hawkish central banks. By itself, this is not conclusive evidence that the Fed should cut substantially, as in the first instance it must be guided by the needs of the US economy. But in the fog of uncertainty that surrounds monetary policymaking, the fact that the Fed has maintained tighter policy than that of most other central banks in similar circumstances should add to its confidence that sizeable loosening at this point will not be premature.

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