Listen: The Decisive | Episode 13 - How US Monetary Policy Works

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Kristen Hallam  

You are listening to The Decisive podcast insights and analysis to empower confident decision-making.

Welcome to another episode of The Decisive podcast from S&P Global Market Intelligence. I'm your host, Kristen Hallam. And today, we're looking at how U.S. monetary policy works, a very timely topic with a highly anticipated Federal Open Market Committee meeting coming up in September. Joining me today from Market Intelligence is senior U.S. economist, Lawrence Nelson. Welcome, Lawrence.

Lawrence Nelson   00:00:44

Thanks for having me, Kristen.

Kristen Hallam   00:00:45

Lawrence, let's start high level before we get into the nuts and bolts. The Federal Reserve System, also known as the Fed has maybe not been around as long as some people might have thought when did the Fed come into being?

Lawrence Nelson   00:01:01

The Fed was established by the Federal Reserve Act in 1913, meaning, it's actually been around for less than half the entire history of the United States. It's actually our third attempt at a central bank. The first was established in 1791 to deal with the post-Revolutionary War debt and establish a common currency. When its charter was up for renewal, 20 years later, it was not renewed, and that bank closed in 1811 we tried again in 1816 to handle the debts from the War of 1812, but again, a 20-year charter was not renewed, and that bank closed in 1836. But the banking system was beset by panics throughout much of the latter half of the 1800s, we had at least one banking panic per decade every decade following the Civil War. So after a particularly bad panic in 1907, Congress was motivated to try one more time to reconsider a central bank. A monetary commission was established. And after much legislative debate and back and forth, eventually, the Federal Reserve Act was presented to and signed by President Woodrow Wilson in 1913. The Federal Reserve Act established the Federal Reserve Board, which is known today as the Board of Governors. It's the governing body of the Fed, based in D.C. But because it's a federal system, the country was divided into 12 districts with one reserve bank established each district. The reserve banks are supervised by the Board, but they operate independently in many respects. And so, the fact that this formulation of a central bank, the Federal Reserve, has endured for so much longer than our previous attempts is really a testament to the strength of this federal system born of compromise.

Kristen Hallam   00:02:48

The third time was the charm then?

Lawrence Nelson   00:02:50

Exactly.

Kristen Hallam   00:02:52

And, Lawrence, what was the Fed created to do exactly? What are its main functions?

Lawrence Nelson   00:02:58

So there are five functions of the Fed. Given its origins in response to the series of banking panics, it should come as no surprise that one of them is to promote the stability of the financial system. Today, it does that via a macroprudential approach. That just means they're looking for systemic risks that pose threats to the stability of the broader financial system, but it also functions to promote the soundness of individual institutions by regulating and supervising individual banks. It also fosters the safety and efficiency of the settlement and payment systems. So all our cash, all our currency, that's from the Fed. The check clearing, electronic payments, the Fed is there to support all of that. The Fed also promotes consumer protection in financial services and community development. This entails issuing and enforcing various protections for consumers. This is a responsibility that's shared with various other federal agencies. And lastly, but certainly not least, the Fed conducts monetary policy. The Fed was actually not originally intended to conduct monetary policy. Monetary policy was not mentioned in the original text of the Federal Reserve Act. It was not until the 1920s when the Fed began to adjust at the discount rate and buy and sell government securities to achieve macroeconomic objectives. Then in 1935, after the Great Depression, the Federal Open Market Committee was established to formally function as the monetary policy arm of the Fed and try to achieve macroeconomic outcomes that would hopefully avoid a repeat of that economic catastrophe.

Kristen Hallam   00:04:33

So far, their report card on that is clean. We haven't had another one, touch wood.

Lawrence Nelson   00:04:37

Fingers crossed, fingers crossed.

Kristen Hallam   00:04:38

Fingers crossed, yes. So lots of functions. But as we mentioned in the intro, it's the monetary policy function that we're focusing on today. The Federal Open Market Committee, or the FOMC as it's known, that's the body that sets monetary policy. So who's on the FOMC?

Lawrence Nelson   00:04:59

The FOMC is comprised of the Board of Governors and reserve bank presidents. There are seven members on the Board of Governors. They are appointed by the President and confirmed by the Senate. They all serve 14-year terms with one new term beginning every two years, meaning every president gets two cracks at getting a nominee on the Board of Governors. The President also gets to nominate the chair of the FOMC as well as the Vice Chair and Vice Chair of Supervision from among the board members. These nominations are also confirmed by the Senate. And all seven members of the Board of Governors are permanent voting members of the FOMC, meaning they vote at every meeting, every year for as long as they serve in their term. The remaining voting members of the FOMC come from the Reserve Bank presidents, five of the 12 reserve bank presidents vote at every meeting, the President of the Bank of New York is a permanent voting member given New York's importance to the financial system. The other four members rotate annually. This year, for instance, the other four voters are Thomas Barkin of Richmond; Raphael Bostic of Atlanta; Mary Daly of San Francisco; and Beth Hammack of the Cleveland Fed. She's actually the newest Fed President. Reserve bank presidents are nominated by the bank's Board and approved by the Board of Governors. So between the seven governors on the Board and the five reserve bank presidents, there are 12 votes cast at every FOMC meeting. The remaining seven bank presidents, though they may not vote, they still attend the meetings and participate in the discussions.

Kristen Hallam   00:06:34

So everyone gets a voice, but not everyone gets a vote... Got it.

Lawrence Nelson   00:06:37

Exactly, exactly.

Kristen Hallam   00:06:39

And how often do they meet, or should I say how many times a year is the market on edge about the outcome of these meetings?

Lawrence Nelson   00:06:46

The FOMC meets eight times a year. That's twice a quarter, so every six to seven weeks. The meetings last two days, they begin on a Tuesday and end a Wednesday with the decision announced at 2:00 p.m. Eastern. The decision is announced via an updated policy statement. Then at 2:30, the Chair of the FOMC comes out and gives a press briefing. The FOMC announces what, if any, policy actions were taken at the meeting, gives an assessment on recent economic developments, as well as the outlook. Then three weeks after the meeting happens the minutes for each meeting are released. This is just a high-level overview or summary of the conversation that took place, it doesn't really ever list any names behind any statements or anything like that. We do get that information, though, when full transcripts are ultimately released. So those are released with a multiyear lag. The most recently available transcripts are from 2018. So it's going to be a while before we, yes, it's going to be a while before we learn what was said during the COVID meetings and who was saying what in response to a the inflation resurgence thereafter. But even outside of those meetings, there's a lot for markets to pay attention to. FOMC members are in constant communication with not just each other, but with the public and to markets, how they're viewing economic developments and what the implications are in their minds for policy. The chair also testifies before Congress twice a year on what's going on with the economy and how monetary policy is handling it. there's plenty for markets to pay attention to, even upside of those eight meetings.

Kristen Hallam   00:08:25

And I'm sure it keeps you pretty busy throughout the year as well, doesn't it, Lawrence?

Lawrence Nelson   00:08:28

Oh, yes, Fed watching is a full-time job.

Kristen Hallam   00:08:31

Now, Lawrence, has there ever been a time in the Fed's history when the FOMC has made a rate decision outside of those scheduled meetings?

Lawrence Nelson   00:08:40

Yes. It is unusual, but it's not unprecedented. So back in early August, this past year, when there was a good deal of financial volatility in the wake of a softer-than-expected July inflation report as well as an unexpected rate hike in Japan. The stock markets, equity values were plunging. So many were calling for the Fed to step in with an unscheduled intermeeting rate cut. So we looked back and found that there have been seven events since 1987 that led to unscheduled cuts and one that led to an unscheduled hike. So in nearly 50 years, it's only happened 8 times. It's an emergency-only situation, breaking glass in case of emergency, like the events which prompted these unscheduled policy adjustments were things like recessions, wars, financial collapses, pandemic, really -- it has to be a severe shock that poses a fundamental threat to the economy. And so for the Fed to step in and do that sends a pretty clear signal that there is something fundamentally wrong that needs to be addressed immediately. It can't wait a few more weeks for their next scheduled meeting. So it's something that the Fed is prepared to do, but they have to be very cognizant of the message that such an action sends.

Kristen Hallam   00:09:58

I like the way you explained that: In case of emergency, break glass. It's got to be pretty serious. So, Lawrence, what guides the FOMC's decisions on monetary policy?

Lawrence Nelson   00:10:09

Congress amended the Federal Reserve Act in 1977 to give the FOMC three explicit goals. Those goals are maximum employment, stable prices, and moderate long-term interest rates. Now these three goals collectively and somewhat confusingly are often referred to as the dual mandate because it is commonly understood that when an economy is at maximum employment, with stable prices, this organically creates the conditions necessary for interest rates to settle at moderate levels. So it's really only necessary for the Fed to target maximum employment and stable prices with its policy actions. And its policy actions generally involve adjusting interest rates. So trying to manage all three of those at the same time would be rather challenging. But it's appropriate then for them to just focus on maximizing employment and stabilizing prices, and the interest rate situation will take care of itself once they've tackled the first two goals.

Kristen Hallam  

And so how do you define what maximum employment is? And how do you define price stability?

Lawrence Nelson  

Maximum employment is actually not explicitly defined when assessing the state of the labor market, the FOMC considers a broad range of indicators. They look at things like unemployment rate, the number of underemployed the labor participation rate, how difficult it is for workers to find work or how difficult it is for employers to find employees. But the level of maximum employment is generally understood to be determined by nonmonetary factors. Think things like demographics. And these things may change over time, and they may not be directly measurable. So it's seen as appropriate for there not to be any fixed goal. The Fed just generally tries to maximize employment whatever that means. On the other hand, price stability is explicitly defined. It is defined as 2.0% inflation per year as measured by the PCE price index. So you may ask why 2%? Why not 0%? Prices don't get any more stable than 0% inflation. Aiming for inflation a little above 0 allows interest rates to settle moderately higher than they would at a 0% inflation rate. And this enables the Fed to have room to respond to a weak economy by lowering rates. At the same time, you also have to think about how inflation going negative is very bad, too. And if you're targeting 0% inflation, that means at some point, inflation is likely to fall below that target. And this is a very bad outcome for a lot of reasons, but the one I'll highlight here is you think about what it does to consumer spending. Why as the consumer would you spend money on something today if you could just wait a week or a month, and it's going to be cheaper? If you know it's going to be cheaper, you're not going to spend today. And so that reduced spending today reduces production. The reduction in production leads to a reduction in employment. Lower employment feeds back into lower spending, and it becomes a vicious cycle, and that cycle perpetuates to overall economic weakness. So that's a very bad outcome that you don't want to invite by targeting inflation as low as 0%. And then one other thing I'll say on these goals, in Fed-speak parlance, how Fed officials may view these different goals or they may assess the risks around these goals differently at any point in time, and how they may categorize the balance of risks, leads to a distinction between what is called hawks and doves. And inflation hawk is someone who is more concerned about the upside risk to inflation or an overheating economy and they would then tend to favor more restrictive policy that seeks to prevent the economy from overheating and restraining inflation. On the other end of the spectrum, you've got doves. Doves emphasize softer policy, which is more supportive of growth, less concerned about the inflation risks. And one thing we've seen as we've gone from the pre- COVID economy when inflation was running below target, then COVID shutdown, the economy needed some juice, so everyone became a dove. And then once the economy recovered and inflation took off, everyone started to sound a lot more hawkish. Now as inflation is coming back down towards 2%, these positions are changing again as members who previously were sounding very hawkish on inflation are now starting to sound more concerned about the risks on the employment side of the dual mandate. How these goals are not just defined but weighted amongst policymakers, that changes over time in regards to economic circumstances, which I think is appropriate. You wouldn't want everyone to always only be worried about one side of the dual mandate. And as we've seen over the past few years, the risks around those are not always the same. We've been dealing primarily with risk around inflation for the past few years. And now we've made progress there, and we're starting to see risks on the employment side come back into play. So it's appropriate that these views, the hawkish and dovish sentiments of policymakers are constantly evolving, reacting to economic developments.

Kristen Hallam   00:15:13

So, it's not once a hawk always a hawk, or once a dove always a dove, right?

Lawrence Nelson   00:15:17

Yes, exactly.

Kristen Hallam   00:15:19

One quick follow-up question for you there. That 2% inflation target, the Fed has set that target? And how long has that been the target?

Lawrence Nelson   00:15:27

It's been explicitly stated as the target by the Fed since 2012. Prior to that, it was implicitly 2%, but there was a lot of debate within the committee about whether it should be exactly 2%, over what time horizon should be hit. I don't want to say globally that it's everyone's target, but most other central banks which have a price stability target, 2% is the target. So it's commonly accepted as an appropriate number.

Kristen Hallam   00:15:54

All right. Thanks for that additional context there. So how does the Fed achieve these goals of maximum employment and price stability? The main tool that the FOMC uses is the federal funds rate, right?

Lawrence Nelson   00:16:11

That's right. The Fed has several tools and targets at its disposal, but first and foremost among them is the target for the federal funds rate. So federal funds are reserves held by banks in their Federal Reserve bank accounts. Reserves in excess of those banks' liquidity needs can be lent to other institutions in need of greater liquidity. These federal funds loans are done on an overnight and unsecured basis, and then the federal funds rate is the interest rate charged on these overnight loans. So, where the Fed chooses to set their target for the federal funds rate, anchors short-term treasury yields and other interest rates. And when they lower that fund's rate target, that is tantamount to easing policy because lowering interest rates causes rates to decline in financial markets, this loosening of financial conditions is necessary when the economy may be sluggish or inflation is low and we need to give it a boost through some more stimulative financial conditions. On the other hand, raising the funds rate is equivalent to tightening policy. Tightening financial conditions would be appropriate when the economy may be overheating or inflation is too high and the Fed wants to restrict activity. How does the Fed actually achieve this target of the federal funds rate? Prior to the 2007, 2008 financial crisis, the Fed would manipulate the level of reserves in the banking system through a process known as open market operations, which is really just buying and selling securities. It would fine-tune the supply of reserves relative to the banking system’s demand for reserves on a daily basis to keep the funds rate near its target. Now as part of the monetary policy response to the financial crisis, the Fed undertook some quantitative easing, which raised the level of reserves in the banking system so much that the funds rate would now fall to 0, if not otherwise supported. The Fed provides a floor on their target for the federal funds rate through the use of administered rates. And these administered rates are the interest on reserve balances and the rate offered at the overnight reverse repurchase facility. Now the interest on reserve balances or the IORB is the rate paid by each Federal Reserve Bank to its member institutions on the reserves that are held overnight in their Fed accounts. However, banks are only a fraction of the overnight lending activity. Money market funds, government-sponsored enterprises, primary dealers with excess cash to invest or lend, they participate actively in the overnight funding market as well. And these nonbanks do not earn the IORB, so the Fed offers them the overnight reverse repurchase facility. A repurchase agreement, repo transaction, shorthand for repurchase, is a short-term agreement to sell a security and buy it back later at a slightly higher price. The implicit interest rate in this slightly higher price is referred to as the reverse repo rate. So this transaction effectively absorbs liquidity from its counterparties while paying them an overnight interest rate. Economically, this is equivalent to an overlight loan made to the Fed or an overnight deposit. And again, these nonbank institutions would not lend this excess cash to other institutions at a rate lower than that which they could earn by lending it to the Fed. So the reverse repo works similarly to the IORB rate by providing a floor on these overnight lending rates offered by this broader set of market participants. Now overnight market rates could still rise above the target range with just the presence of the IORB and the reverse repo facility. The Fed uses what are called liquidity backstops to maintain the upper end of their range. The administered rates are there to effectively absorb liquidity in the overnight funding market, liquidity backstops are there to provide it. And because the rates at these facilities are slightly above prevailing market rates, they tend to be unattractive for market participants under normal circumstances. So given the ample level of liquidity in the financial system, these facilities play a much less active role in the realization of the FOMC's target for interest rates relative to those administered floor rates.

Kristen Hallam  

The federal funds rate is the primary tool, but how else does the Fed seek to achieve its mandate?

Lawrence Nelson  

Besides the funds rate, the Fed has at its disposal balance sheet policy and forward guidance. So the Fed's balance sheet is comprised of treasury and mortgage-backed securities. When the Fed wants to make policy more accommodative, they will purchase additional securities, expand its balance sheet through what is known as quantitative easing. On the other hand, when they want to make policy less accommodative, they will undertake quantitative tightening, which is sales of securities on their balance sheet or the runoff without reinvestment of maturing securities. So when the Fed undertakes quantitative easing and purchases securities, this raises demand for those securities, increased demand raises the prices and higher prices, lower yields. This serves as an effective complement to funds rate policy because funds rate policy works most directly on the shorter end of the yield curve, whereas balance sheet policy tends to move the longer end of the yield curve. So by working with these two policy instruments in tandem, the Fed is able to steer the entire yield curve. Forward guidance is a communication strategy whereby the Fed seeks to align market expectations with the likely course of future monetary policy. Long-term yields are determined by the expected path of short-term yields and a term premium. Forward guidance gives defend some additional control over longer-term yields beyond those that are most immediately impacted by the current set of monetary policy. And all that Fed speak we talked about earlier, the statement, the press briefing, the interviews, is every time a beneficial speaks in public, that is part of forward guidance. They're trying to make sure that markets understand the likely future course of policy so that they can price things appropriately.

Kristen Hallam   00:22:21

Managing market expectations, not an easy task.

Lawrence Nelson   00:22:24

No, absolutely not.

Kristen Hallam   00:22:27

Lawrence, how does the Fed influence macroeconomic outcomes? What are the main transmission channels for monetary policy?

Lawrence Nelson   00:22:35

When the Fed sees that growth is soft or inflation is low, they will seek to ease policy. They would do this by lowering rates, quantitative easing, giving some more dovish forward guidance in the hopes that engenders looser financial conditions, which are more supportive to growth and inflation. On the other hand, when the economy may be overheating or inflation is high, they will seek to tighten policy with higher rates, quantitative tightening and more hawkish forward guidance. The way though that these policy actions are actually transmitted through to the macro economy are interest rates, equity values and the dollar exchange rate. As mentioned previously, changes in the funds rate lead directly to Treasury yields, Changes in Treasury yields subsequently affect changes in consumer loan rates, business loan rates, corporate debt yield and mortgage rates. Higher interest rates generally tend to discourage spending and productivity. So when the Fed raises rates, spending and production go down.  That slows growth and hopefully brings inflation back down. Housing, for instance, is a particularly interest-sensitive sector.

Kristen Hallam   00:23:45

Well, you don't need to tell me that...

Lawrence Nelson   00:23:47

No, yes. You just look at what's going on with existing home sales since rates began to rise in 2022. They have fallen off a cliff and they are struggling to get back up. So you can see how dramatically the impacts of a change in monetary policy can affect the rest of the economy. Now so stock prices, more broadly, equity values, are inversely related to interest rates. The equity cost of capital influences business fixed investment. When interest rates go up, equity values go down. That increases the equity cost of business fixed investment and the higher cost, less investment. Similarly, equities are a significant source of household net worth. So lower equity values decreased spending through the so-called wealth effect. We estimate that for every $1 decline in household net worth, consumer spending is reduced by $0.03 to $0.05 over time. So given the dramatic swings that you can see in equity markets around policy adjustments, you can see how this would be such a significant driver of spending activity. Now the relationship between interest rates and exchange rates is multidimensional and nuanced, which is to say complicated. But one identifiable effect of significance involves policy-induced changes in U.S. interest rates relative to those in other countries. Because of the soundness of U.S. legal institutions and the property rights as well as the fact that we are the broadest and deepest capital market, investors tend to look favorably on investing here. Therefore, when U.S. interest rates rise, investors move capital here. This involves buying dollars with foreign currency, which raises the value of the dollar. This then raises the foreign currency price of U.S. exports and it lowers the dollar price of foreign imports. Now the net effect here is downward pressure on net exports and GDP. So again, we see how raising interest rates restricts growth. At the same time, import prices factor into the consumer and PCE price indexes. So an increase in the dollar puts downward pressure on inflation. The macroeconomic impacts of monetary policy are felt directly on the demand side of the economy. The Fed has little control over the supply side. That's really more of a fiscal matter. That's for Congress and the legislature to decide. To the extent that inflation arises from an imbalance between supply and demand, the Fed's monetary capacity to influence the demand side of the economy, either by stimulating or dampening demand is how they can bring the supply and demand back into balance and hopefully restore price stability.

Kristen Hallam  

Curious as to what types of data the FOMC members look at as they try to achieve these goals, maximum employment and stable prices. I'm sure they look at reams and reams of data, but are they interested in forecasting, now casting more retrospective data...

Lawrence Nelson   00:26:49

I think it's definitely safe to say they look at everything they possibly can. They look at both published official data, they look at forward-looking forecasts. In fact, I'd say that every FOMC meeting includes a briefing from the Fed staff discussing their updated forecast and the outlook for the economy. However, we've really seen an emphasis on data dependence from the Fed over the past several years, that's arisen largely from the uncertainties of the outlook and the difficulties of forecasting in the post-COVID economy. But it's been pretty clear for the past few years, at least that they're really emphasize and seeing what's actually going on with the data. And again, returning to the dual mandate. On the inflation side, the Fed prefers to look at the PCE index over the Consumer Price Index, which a lot of other people pay attention to. But the Fed prefers the PCE index because it adapts more quickly to changes in spending patterns.

Kristen Hallam   00:27:43

PCE is personal consumption expenditure. Is that right?

Lawrence Nelson   00:27:48

Yes, personal consumption expenditures price index. That index adapts more quickly to changes in spending patterns. So it's considered to be a better real-time measure of what people are actually spending their money on and how much they're paying for it. We also hear policymakers spend a lot of time focusing on the core PCE price index. The core index is the one which excludes food and energy. Now of course, they understand that consumers still pay a lot for food and energy, but those tend to be more volatile. So stripping them out is thought to give a better sense of the underlying trend and dynamics of inflation and, therefore, give a better sense of where inflation is going. But again, of course, they do still pay attention to the food and energy indexes because those things matter. And they also look at breakdowns, other details within the overall index of looking at how much goods prices are rising versus services prices, what's going on with rent and shelter costs, and things like that. Because although the Fed's 2% target is for the overall index, that doesn't necessarily mean they're going to hit 2% for every single component of inflation. Prices of certain categories are going to rise or fall at different rates. But just looking at this breakdown gives them a sense of when they're missing their target, as they are now, what is contributing most acutely to that, and so that they can make sure that is considered when they determine what the appropriate policy stance is. So on the labor market side, again, there's no explicit target there. So there's not like one clear North Star number that they're trying to hit. But they look at everything they can. They look at all the monthly payroll numbers that we all pay attention to -- payroll gains, the unemployment rate, participation rate -- to get a sense of the level of tightness in the labor market. We've heard officials repeatedly cite figures from the Job Openings and Labor Turnover Survey or JOLTS, the JOLTS report. We've heard Powell mention that a few times in his press briefings, looking at the ratio of job openings to the number of unemployed, how many people are quitting their jobs, what's the hiring rate, stuff like that. And in addition to all that quantitative, that hard data, the Fed also spends a lot of time gathering anecdotal evidence from their contacts with local businesses and other organizations in their district to really get a sense of how these economic agents at the ground level are engaging with the economy and what that implies for the broader economy. And it's interesting to hear them talking about the stories they're hearing from these individuals, whether it's a consumer or a business to the extent that those differ from what's the picture being painted by the aggregate data. So all of that is factored into their decisions at every meeting and how they're going to calibrate the stance for monetary policy.

Kristen Hallam   00:30:31

Lots and lots of data to go through, as I suspected. And the anecdotal evidence is interesting as well. Lawrence, when the FOMC meets later this month, what are the main news items that we can expect to get out of that other than a rate decision?

Lawrence Nelson   00:30:48

As hinted to already, policymakers have pivoted to having roughly equal concern about the employment side of their dual mandate as they are the inflation side. This is a pretty far cry from where we were even 5 or 6 months ago when inflation was resurging again and over the first quarter of the year, we've seen progress getting inflation back to 2% resume over the second quarter, and that appears to have continued through July. And this has prompted policymakers to set up a pivot in monetary policy towards easing policy in his public remarks, during the Jackson Hole Economic Symposium last month, Chair Powell erased all doubt or uncertainty about when that might happen when he said that the time has come for policy to adjust and the direction of travel is clear. In other words, a cut in September is coming. There's no doubt about that. The question now is how large will that initial cut be and what will the pace be thereafter. Many in addition to calling for an intermeeting cut during the financial volatility in early August, many of those same voices were also calling for a 50 basis point policy adjustment in September. That would be more than is typical. And I would say the case for that has diminished significantly now that financial markets have stabilized. For our part, we are in the process of developing our September U.S. macro forecast. The transition to greater concern with labor market conditions does not mean the inflation mandate has been forgotten nor does it mean the Fed has abandoned its data dependence. Consequently, our policy outlook really remains contingent on how the rest of that forecast takes shape. There's one more important data release that kind of really informs what we would expect to happen, and that is the August employment report, which will be released on Friday, September 6, which I realized may be old news by the time this podcast goes out, but it's still something that we're waiting for as we determine what to expect at the September meeting. I think it would really take a horrendous number there to prompt the 50 basis point cut, like negative payroll growth, the unemployment rate going above 4.5%. Otherwise, I think a 25 basis point cut seems the most likely. Looking beyond the September meeting, we've heard policymakers express support for kind of a methodical pace to easing. That's pretty nebulous. And so it's hard to determine what exactly that means. I think that kind of doubles down on the data dependence. The enthusiasm for rate cuts is not equally shared by all members of the FOMC. For instance, Governor Michelle Bowman has continued to emphasize the upside risk to inflation in her public comments. So it will be interesting to see how, if at all, this manifests at the September meeting. It's possible she may issue a dissenting vote against a rate cut. I think that's a little unlikely, given the sort of consensus-oriented approach that Chair Powell has taken to making decisions. But it's possible. Dissents do happen. It's been a few years since we've had a formal dissent. But that would be one way in which Michelle Bowman could continue to emphasize that she's more concerned about the inflation side of the dual mandate. Another possible approach would be what she submits in her rate projections. September is a meeting at which all participants of the FOMC submit forecasts for growth, inflation, unemployment, and interest rates in what is known as the summary of economic projections, or SEP. So we will get what they believe will be the appropriate setting for the funds rate at the end of 2024. And since there's only two meetings left after September, it's pretty easy to infer from those 2024 data points this year, what they are expecting to happen over the next two meetings. So any official who is less enthusiastic about beginning to ease policy may be inclined to show that interest rates finish 2024 where they are coming out of the September meeting. That is certainly something to watch for at the meeting in a couple of weeks, and it's definitely something we will be paying very close attention to.

Kristen Hallam   00:34:50

So it sounds like there could be a little drama at this meeting then?

Lawrence Nelson   00:34:54

Yes. There's always something to watch for. But this time, that's definitely something that we and others will be zeroing in on, for sure.

Kristen Hallam   00:35:00

You've given us a lot to think about between now and then. It's been really educational for me and hopefully, a good refresher for our more seasoned listeners. Any final thoughts as we wrap up?

Lawrence Nelson   00:35:11

One other thing to note, I would say, is that later this year, the Fed is going to undertake a review of their monetary policy framework. This is important because the framework addresses how the Fed defines and achieves its objectives. A lot of what we've talked about today is subject to review and change. We could see changes to the characterization of the maximum employment objective or the price stability target. I think it's unlikely they would change the inflation target from 2.0% because they're not at 2.0%. And to change when they're not at that target undermines their credibility. This is a sentiment that has been expressed widely by policymakers of late. Several have suggested that the Fed should just raise their target. 3% is not that different than 2%. So why not just raise it to three? But the counterargument to that is that a lot of the success we've had in bringing inflation back down from where it was without having the kind of recession that normal economic theory would suggest is necessary is attributable to the fact that the Fed has hard-earned credibility as responsible stewards of price stability. And I don't think they would cast that off lightly. And I think raising the inflation target before they've hit it risks doing that. But maybe they would make a smaller adjustment, maybe they might redefine the horizon over which that target is to be hit or make it more of a range, something like that. I think that's less likely. More likely changes could be changes to the communication strategy and emphasis on alternative scenarios rather than just the base scenario, giving a sense of how the Fed would react to different economic developments and what the appropriate policy would be. They may also seek to change how the summary of economic projections is presented. There's been a lot of talk that the way it's done now is somewhat confusing and doesn't really lend itself to the public understanding the Fed's reaction function. And it would be interesting to see what changes would come about there.

Kristen Hallam  

Maybe we'll have to have you back on the podcast once that is wrapped up, it will be interesting to see if they move the goalposts or not?

Lawrence Nelson  

Hopefully, not everything I said will have been wrong by then, but we'll see.

Kristen Hallam  

Thank you so much, Lawrence, for sharing your insights with us today. I hope our listeners learned a lot about how monetary policy actually works in the U.S. I certainly did.

Lawrence Nelson  

Thanks, Kristen.

Kristen Hallam  

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