The Decisive | Season 5 Ep.3 - Federal Reserve in Focus: Rates, Risks, and the Road Ahead

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Kristen Hallam:

You're listening to the Decisive Podcast, insights and analysis to empower confident decision making. Hello, I'm Kristen Hallam, your host for this episode of the Decisive Podcast. The U.S. Federal Reserve is always in the spotlight, and this month is no exception. We're going to talk about our outlook for rate actions in 2026, the data the Fed uses to make those decisions, and recent and upcoming personnel changes at the central bank. And yes, we will also discuss potential replacements and complications for Fed Chair Jerome Powell, whose term as chair is set to expire in May. To tell us more, we have with us Lawrence Nelson, an economist in our US Macroeconomic team at S&P Global Market Intelligence. Lawrence covers the Fed. It's great to have you back on the podcast, Lawrence.

Lawrence Nelson:

Thank you, Kristen. Pleasure to be back.

Kristen Hallam:

So let's start with the hot topic of the Justice Department's investigation of Fed Chair Jerome Powell. How might that complicate the transition to a new chair?

Lawrence Nelson:

Yeah. So, the announcement, or revelation of this investigation, it really caught everyone off guard. The story itself of what this all centers on is the comments Powell made during congressional testimony regarding the ongoing renovations of the Federal Reserve headquarters and some cost overruns. That story got a lot of attention in the middle of last year. It all came to a head with a highly publicized tour of the renovation site in which hard hat wearing President Trump and Powell walked around. They took the sites in, but ultimately afterwards, Trump seemed to move past the issue, didn't seem inclined to dismiss Powell over the situation. So when we got this statement from Jerome Powell on Sunday night on January 11, it really felt like it was out of the blue.

And what was also really interesting about it was the degree to which Powell's rhetoric in his statement was such a marked escalation from what we've heard from him in the past on this. He very much explicitly tied this latest development to the administration's dissatisfaction with interest rate policy. So it's clear now that Powell is prepared to take this

fight head on and in full public view. So the ways in which we could see this complicating the transition to the new chair, I'd say there's a short-term issue and potentially a longer-term issue. The short-term issue is we've already heard two Senate Republicans indicate that they would not vote to advance any Fed nominee until this investigation is resolved. Those are Senators Tillis and Murkowski. Tillis is particularly notable because he sits on the Senate Banking Committee, which is where any nominee would testify before their nomination gets a vote on the full Senate floor. The Republicans currently have a 13-11 majority of that committee. So if Tillis and all 11 Democrats vote not to advance the nominee, they would not then make it forward to get a full Senate floor vote.

The longer-term complication for the next Fed Chair would be in our view, this development raises the probability that Powell might choose to stay on the board as a governor after his term as chair expires. And traditionally chairs have resigned from their terms as governor when not reappointed to their leadership role. Powell's term as chair expires in May of this year, but his term as governor does not expire until January 2028. So for as long as it has been clear that Trump does not intend to reappoint him as chair, which has been the case for the past year of Trump's second term, Powell has faced this question a lot from the press, but he has declined to comment each time. He was dancing around it. But in our view, this certainly does raise the odds that he may choose to remain on the board while this new chair is taking over. And having Powell kind of lingering there in the background may pose a bit of a challenge for this new chair as they try to step into this new leadership role.

Kristen Hallam:

Very, very interesting. And that certainly would be. I don't know if awkward's the right word, I'll just stick with interesting, to have your predecessor looking over your shoulder as you step into these very big shoes. Right?

Lawrence Nelson:

Yes, exactly.

Kristen Hallam:

Yeah. So Lawrence, how might the DOJ investigation impact monetary policy?

Lawrence Nelson:

So here we don't really see any direct consequences. The Fed is still a consensus and data-driven organization. I don't think that this investigation would really enter into their reaction function. They're going to continue to make decisions based on economic data, not any sort of outside developments. They're going to continue to prioritize the wellbeing of the economy. So I don't think that this really would influence decisions one way or another. Could see perhaps some at the margin long term maybe this factors in is--it would be indirectly and it would be through how this shapes who they choose to nominate as the next Fed Chair.

It's been reported that it is a priority for the administration to ensure that Powell does resign from the board when he's not reappointed as chair so that if that factors into the decision at all it might convince them to perhaps pick a nominee who they think Powell would be more comfortable with. So to the extent that that influences the decision as to who's going to be the next Fed chair, and to the extent to which who the chair is actually influences monetary policy outcomes, I could see maybe this is all very an indirect route through which this investigation shapes monetary policy. But I think, as I'm hopefully conveying by adding all these qualifiers, I think the impact here is very dubious. It's because the FOMC is structured that policy is made by committee. It's a committee of 12 voting members. The chair does frame the debate and kind of set the table for the conversation at each of their policy meetings. But ultimately they only have one vote. So it's really only through their ability to forge a consensus among those on the committee that they are actually able to influence monetary policy outcomes.

Kristen Hallam:

Yeah, thanks for walking us through that. Again, it'll be interesting to keep an eye on for sure. So you talked about Powell's response. What other responses have we seen in the wake of the investigation, including the reaction of other Fed officials, past and present?

Lawrence Nelson:

Right. So I think what was so notable about Powell's response was how he directly placed this in the broader context of political pressure. And in, in that way, he put this issue of central bank independence very much at the fore of the conversation. Central bank independence, what we mean by that is we mean monetary policy decisions are set independent from political influence or political pressure. This is something that there is

universal support for throughout the macroeconomic community and central bankers around the world. It's because political decision making generally favors short-term outcomes, whereas the task of a central banker is to think about the long term.

Just a quick example. If a politically influenced central bank might choose to lower interest rates more rapidly than otherwise might be necessary so as to prioritize rapid growth, boost employment, something that politicians might find expedient as we're heading into an election year. But those lower interest rates in the long run will likely lead to higher inflation, which as we're experiencing right now, is not a desirable macroeconomic outcome. So because of that, there is near universal, if not unanimous support for central bank independence. We've heard already from a chorus of current and former Fed officials who have voiced their support for Powell and for central bank independence more broadly. John Williams, the president of the New York Fed, Austan Goolsbee of Chicago, Anna Paulson of Philadelphia, Federal Reserve Governor Michael Barr, have all been among those on the current Fed who have, since the investigation was revealed, backed Powell. We've also heard from all three living former Fed chairs who signed a statement rebuking the investigation. And even internationally, several international central bankers signed a joint statement offering solidarity with Powell. So it's clear that among the economists and the central bankers around the world that there is strong support for Powell in this investigation to the extent that it is part of this broader battle for central bank independence here in the U.S.

Kristen Hallam:

All right, now, you touched on it in your response just now. The balance that the Fed has to achieve between economic growth and keeping inflation in check. And you've told us on this podcast before how US monetary policy works. It's a great episode. I will be dropping a link to it in the description of this episode, so I highly recommend our listeners check it out. But for the sake of convenience though, for the listeners of this episode, Lawrence, could you give us a quick refresher on the dual mandate and the types of data the FOMC uses to inform the decisions on rates?

Lawrence Nelson:

Sure. So the dual mandate is in the Federal Reserve Act. It tasks the Federal Reserve with seeking to achieve maximum employment and price stability. Starting with the price stability mandate, the Fed has interpreted this to mean a target of 2% inflation. Their preferred measure to gauge whether or not they're achieving that target is the personal

consumption expenditures or PCE Price Index. There's also the widely and well-known Consumer Price Index which is an alternative measure. The Fed has indicated though that they prefer the PCE Index because it is a broader measure of inflation. The PCE Index includes rural spending, whereas the CPI is an urban index.

The PCE index also includes spending on consumers’ behalf such as employer paid insurance. And then one of the key benefits of the PCE index is that it includes dynamic weighting, which means that it responds in real time to changes in consumer spending behavior. So for instance, if the price of beef rises and consumers shift their spending to chicken, the PCE index captures that change in behavior more quickly than the Consumer Price Index would. So because of that it's a bit more responsive. Also, the weights are structured differently between the two indexes. The PCE index has a higher weight on healthcare spending and lower weight on shelter spending. Just because of all these factors the CPI tends to run a little higher. And really, I think the dynamic weighting is what really causes the Fed to favor the PCE index over the CPI.

You'll also often hear officials make a distinction between the headline index which is what the official target is aimed at. But you'll also hear them talk a lot about core inflation. Core inflation is the headline index, excluding food and energy. Now, of course, food and energy prices are very important to everyday consumers, but they are also fairly volatile, so they can confuse the signal from the inflation index. And the core index is seen, therefore, as a better gauge of where inflation is going, which is what the policymakers are really concerned about. And then just one other thing on inflation before we turn to employment. One critical aspect of the inflation target is the anchoring of inflation expectations. Expectations are seen as a predictor of future inflation.

If inflation expectations rise, employees will demand higher wage gains. Employers have to raise prices to cover those higher wage gains. So it becomes a vicious cycle. So it is very important that inflation expectations remain anchored at levels consistent with 2% inflation if that target's going to be achieved. And that is notably something that has been the case over the past few years, even as we've seen inflation remain above target for so long. The Fed has earned a reputation as a responsible steward of price stability, and that has enabled them to ensure that inflation expectations remain anchored even as inflation has been so far above target. And it's what has allowed inflation to come down from as high as it was just a few years ago to where it is today, which is a level still above target, but much closer to target than it is to its peak. And that has all been achieved without a recession, which is what many people thought would be necessary to bring inflation back down to 2% target.

So that in itself speaks to the importance of inflation expectations, and it's why Fed officials are so adamant that they are going to get inflation all the way back down to 2%. They're not satisfied with the fact that it's under 3%, depending on which metric you use. The job is not finished, and they're going to keep working until inflation is all the way back to 2%. Now, on the employment side of the mandate, the Fed has not adopted an explicit target in the way that they have with the 2% inflation target. This is because the maximum level of employment is generally understood to be determined by factors beyond the control of monetary policy. And you think things like demographics and immigration. Those aren't things that changes in interest rates can really influence. So when the Fed is trying to gauge the state of the labor market and how they're doing relative to whatever maximum employment is at the time, there's a whole universe of data out there for them. They pay attention to all of it.

One that we know gets a lot of attention month to month are those monthly payroll reports, whether the number’s up or down, how is it as compares to expectations? That's something that people pay a lot of attention to, but there's very large revisions to those series. So it limits the signal in terms of what the absolute level of the difference is month to month. You'll usually hear when Fed officials are talking about how they see the state of the labor market. One of the first metrics that they will cite is the unemployment rate. So it's a rate, so it's a little more stable. And that's been kind of one of the main drivers of Fed action of late. It was often cited as justification for why the Fed cut by each of their last three meetings of 2025, even as inflation was above target. The fact that the unemployment rate was drifting higher was enough of a signal to warrant making policy more accommodative, even as inflation was above target.

But even beyond those payroll numbers and the employment reports, there's JOLTS data, job openings, hires, initial claims for unemployment insurance. There's plenty of private sector data that the Fed pays attention to. And all, all of this really supports the assessment that we're in this low hire, low fire labor market that suggests that labor markets are cooling, but they're not deteriorating. And that's what we've seen with that upward drift in the unemployment rate. It's up a bit from where it was, but we're still historically at a pretty low level. And so that suggests to the Fed that we're in good shape. The risks have risen on the labor market, but altogether, things could be worse.

Kristen Hallam:

Things could be worse. Yeah. Well, thank you so much, Lawrence, for that. And now our listeners can understand why we did an entire episode on how US monetary policy works.

Lawrence Nelson:

I was just scratching the surface.

Kristen Hallam:

That's right, that's right. That was the short version. So Lawrence, let's step back in the time machine and go back to the US Government shutdown last year. How did that impact the flow of government data that the FOMC relies on? And how might that impact the FOMC's upcoming rate decision?

Lawrence Nelson:

So the timing of the shutdown was certainly not ideal. It began October 1st, just a few weeks after the Fed made its first interest rate cut of the year in mid-September. The Fed lost a lot of the key data it uses to inform its decisions, just as it was debating how to recalibrate policy to this rising risk environment on the labor market side while inflation remained above target. It's notable that while there are good alternative data sources to the government data on the labor market side, you think about things like the ADP private payroll numbers, the Challenger job cut series, as well as while the national claims for unemployment benefits data was not being published, the state level data still was. And so that was something that we were aggregating in real time to see if there was any evidence of a material change in labor market conditions. But so while we have all those good metrics on the labor market side, we don't have similar or comparable data on the inflation side. So that kind of really caused some anxiety among officials as to can we continue to ease policy while we're not really flying blind on the inflation side of the mandate? Ultimately, of course, they did continue to cut. They cut at three consecutive meetings to end the year.

And now while we are slowly catching up, we're still a little behind, we're still a few months behind on certain releases. And even the data that we are getting, there's some gaps in the data because the government wasn't able to collect data during that month of October. So the consumer price index, we're missing a lot of key metrics for October. There's a lot of key series that don't have data for October in the unemployment report. So this is limiting the signal of what we received. And because of that, I think there hasn't really been much information since the December meeting that would suggest a material change in the outlook. And I think that's going to prompt officials to remain cautious while we wait for this

flow of data to get back to normal for us to fully catch up. And until that happens, I think caution is going to continue to be the watchword, at least for the next few months.

Kristen Hallam:

All right, now the FOMC is meeting next week, January 27th through 28th. So, especially given like some of these data gaps that you were talking about, what are we expecting the committee to do on rates at that meeting?

Lawrence Nelson:

We're expecting a hold. I think we're aligned with most who track the Fed. I think that's a pretty widely held sentiment at this point. Nothing in the Fed-speak that we've heard since the December meeting suggests any urgency to cut rates. There are still your, your hawks and your doves on the committee who have their varying assessments of the balance of risks. But given the limited takeaway even from what data we have seen since December, I don't think there's a whole lot of urgency to cut rates at this time. But every meeting's always interesting. And so what we will be watching at the January meeting is kind of what's, what's the forward guidance going to be? What assessment do they make of the recent data? What are future moves conditioned on as well as how is Powell going to handle all the follow-up questions to his statement? During his post-meeting press conference, over the past year or so, he hasn't really leaned into taking these questions of the President's criticism and the administration's pressure campaign.

He hasn't really taken those head on, but now he has with this public statement. So does that change the way that he answers those questions during the post-meeting press conference or does he just let the statement speak for itself? Nothing to add beyond that. So that's certainly something we will be watching with great interest following the meeting next week.

Kristen Hallam:

Fed-speak. I like that like that term there. Wonder if that's a foreign language class you can take.

Lawrence Nelson:

It probably should be.

Kristen Hallam:

So Lawrence, what are our current expectations for the rest of 2026? What action do we expect the committee to take on rates going forward?

Lawrence Nelson:

So we do expect them to remain on pause for the first few meetings of the year. That expectation is based on our forecast that inflation is going to remain sticky over the first half while the unemployment rate drifts up a bit from 4.4 [percent] in December to average 4.7 [percent] for the year. But it's a gradual ascent so it's not something that sets off alarm bells that the labor market is imminently about to deteriorate. So that permits the committee to remain on pause while they wait for these signs that inflation is headed back towards their 2% target. Once they do start to see evidence that the tariff effects are waning and inflation is cooling, we expect them to cut in June and again in December. Those are the only cuts we expect for the year. And those two cuts bring the funds rate down to our estimate of neutral, which is the rate which neither stimulates nor restrains the economy. Important to understand here that this is first of all a highly conditional forecast.

If inflation rises more sharply than we anticipate or if inflation proves stickier than we anticipate or rises, that would compel the committee to remain on pause for longer than we currently expect. Conversely, if labor markets deteriorate more sharply or more rapidly, then that would cause the committee to respond with loosening policy more aggressively than we than we expect and could even compel them to bring the funds rate below that neutral rate to an accommodative stance to bolster the economy. It's also important to note that our forecast is based entirely on the macroeconomic conditions in our forecast. We are not factoring in staffing, changes, the chair or otherwise into our forecast. It's all based on the data.

Kristen Hallam:

And speaking of that, could you remind us who the main candidates are to replace Powell as chair?

Lawrence Nelson:

So the latest reporting indicates that we're down to four candidates. They are Kevin Warsh, who's a former Fed governor, Kevin Hassett, who's the current director of the National Economic Council, Chris Waller, who's the current Fed governor, and Rick Reeder, who is the chief investment officer of BlackRock. It was reported about a month ago that Hassett was the leader in the clubhouse, if you will. But since then, it sounds like maybe it's back to being more of an open horse race. For our part, we're not inclined to handicap the President's thinking. We're in wait and see mode along with everybody else. Treasury Secretary Scott Bessent indicated earlier this week that we may get an announcement as soon as next week. But we've heard similar forecasts before as well, only to still be here sitting and waiting.

So that doesn't really inform our view on when we expect to get the announcement. We'll get it when we get it and we will make of the nominee whoever they are once we know who they are.

Kristen Hallam:

Right. I'm sure you've got your notes ready for when the, when the big announcement comes. Yeah. So, Lawrence, are there any other potential complications around transitioning to a new Fed chair? And are there any other recent upcoming personnel changes at the Fed that you are keeping an eye on?

Lawrence Nelson:

So we already touched on the acute complications stemming from the investigation and what that might bring about. There is one other wrinkle there though to add, and that is that whoever the next Fed chair nominee is widely expected to be nominated to fill the seat on the Board of Governors currently occupied by Stephen Myron. That term expires later this month in January. But if there is the possibility, which we just raised, that Senate opposition could delay the confirmation process of the next Fed Chair--before they can become Fed Chair, they have to be sworn in as a governor. If that gets delayed, there is a passage in the Federal Reserve Act, and I'm paraphrasing here, but it holds that members of the board can continue to serve in their role until their replacement is confirmed. Which means that Myron could remain on the board beyond the expiration of his term this month if the next Fed Chair's confirmation to the board is delayed as a result of Senate resistance. Now, looking beyond that, there were some headlines last month when the Board of Governors

announced that they were renewing the five-year terms of the presidents of the regional banks. Eleven of the twelve presidents’ terms were renewed.

The exception was Raphael Bostic of Atlanta, who announced that he would be retiring when his term expires in February. We don't yet know who will be replacing him, but whoever it is, they will not be a voting member of the board until next year. So that's not an imminent issue or factor to consider into monetary policy, but certainly something to keep an eye on. But speaking of the presidents, every year we get the annual churn of voting regional presidents. There are four presidents who become voting members of the FOMC with the January meeting every year. So this year the new voters are going to be Anna Paulson of Philadelphia, Neel Kashkari of Minneapolis, Lorie Logan of Dallas and Beth Hammack of Cleveland. It's noteworthy that among the more hawkish again, the more inflation worried members of the committee, last year those sentiments were most loudly voiced by the regional presidents who left as voting members of the FOMC last year.

But now the four new voting members of the FOMC this year have also all sounded fairly stridently hawkish in their own right. So I think despite that we get this, this annual churn of four regional presidents, there's still going to be a hawkish contingent on the FOMC. That's still going to remain the case. And I guess looking a little further down the road, presidents of the Federal Reserve banks are subject to mandatory retirement ages. There are three retirements looming in 2028. Thomas Barkin of Richmond, John Williams of New York and Mary Daly of San Francisco all reach retirement age in 2028. So that's looking a little further down the road, but certainly something to keep in mind as the calendar turns over in a couple years’ time.

Kristen Hallam:

All right. Well, we have covered a lot of ground today, Lawrence, and it's time to wrap up our conversation. Any final thoughts for our listeners?

Lawrence Nelson:

Yeah, actually, there's one thing we haven't touched on yet, and that is the legal case of Lisa Cook. So the timing of this or recording this today is actually rather serendipitous because. So this is Wednesday, January 21, and the Supreme Court is today hearing the legal arguments in her case. Just taking a step back, in August of last year, President Trump issued a letter in which he sought to fire Lisa Cook for cause. Lisa Cook contested that letter and denies any wrongdoing, is not facing any charges. So as part of her suit, the lower

courts allowed her to remain in her post as the case made its way through the legal system. It's now made its way up to the Supreme Court and notably the chair, Jerome Powell, has indicated that he will be attending the arguments today. It's not the first time that a chair has sat at the court during legal arguments, but it's not clear if this was something he intended to do or not before the investigation.

But I think it does indicate that he is there to support Lisa Cook. And it is the first time that a chair has sat before the court as it hears arguments regarding the dismissal of the Federal Reserve governor because a president has never tried to dismiss a Federal Reserve governor. So this is the first time that has happened. The case itself hinges on the court's interpretation of the for cause requirement that's listed in the Federal Reserve Act as the only grounds for dismissal of a governor. For cause has widely been understood to mean malfeasance or dereliction of duty. So whether allegations of misstatements in mortgage applications, which is what Cook has been accused of, whether those mere allegations are sufficient cause for her dismissal over something that happened before she was a governor, that would be a broader interpretation of that for cause requirement than is widely understood today. So I think this very much is a pivotal matter in this theme of central bank independence that we spent so much time talking about today.

So it's something we will certainly be watching very closely and as I imagine many will around the world as well.

Kristen Hallam:

As if we didn't have enough to watch already.

Lawrence Nelson:

Exactly.

Kristen Hallam:

All right. Well, all that's left for me to do is to thank you, Lawrence, for sharing your insights with us. And thanks to you, our listeners, for tuning in. Please check out the links in the description of this episode for additional insights in that previous episode that I mentioned. Until next time, thank you for listening to the Decisive Podcast from S&P Global. Please subscribe and join us for next week's episode. Until then, stay curious and stay informed.