The US Federal Reserve might be more dovish than Jerome Powell thinks

Bill Dudley

  If the US Federal Reserve cuts interest rates next week, it’ll be acting in part on a crucial assumption: that monetary policy is currently restrictive, holding the economy back. 

This belief could prove to be dangerous. 

Chair Jerome Powell has argued that the Fed should be aiming toward a neutral monetary policy, on the grounds that recessionary risks in the labor market — highlighted by recent anemic job growth — offset the inflationary risks of higher import tariffs. Hence, I expect the central bank to cut the federal funds rate by a quarter percentage point at next week’s policymaking meeting, because officials including Powell think the current rate of just above 4.0% exceeds the neutral level that would neither stimulate nor impede growth. 

But does it? The economy’s persistent momentum contradicts the notion. The Atlanta Fed’s GDP Now model forecasts real growth of 3.8% for the third quarter, up from a 3.0% estimate in early September. Median growth forecasts for 2025, 2026 and 2027 also increased in the September economic projections of the Federal Open Market Committee. As Powell has often remarked, we know the neutral level — also known as r* — “by its works.” Those “works” suggest that the FOMC’s median estimate of 3.0% for r* is too low.   

Granted, the Fed’s monetary policy doesn’t directly determine economic growth. It operates by influencing broader financial conditions, which have eased a lot in the past year. Stock prices have risen, bond yields have declined and the dollar has weakened. A Goldman Sachs index suggests conditions are at their most accommodative since April 2022, while a Fed-developed index indicates that, as of August, they would boost the coming year’s real GDP growth by nearly one full percentage point. 

To my mind, financial conditions have eased too far — beyond what’s consistent with the Fed’s objectives, and beyond what expectations of further rate cuts alone should merit. The AI investment boom, for example, has lifted the “magnificent seven” tech stocks to the point that they now account for about one-third of the market’s capitalization, up from about one-fifth at the end of 2022. Tariff wars and shifts in some countries’ holdings of dollar assets, not changes in expected interest rate differentials, have pushed down the exchange rate of the US currency. 

These developments add to already significant inflationary risks. Powell has suggested that the impact of higher tariffs on prices can be ignored because it’s a one-time event, not an ongoing increase. Yet this is true only if long-term inflation expectations stay well anchored, which in turn depends on confidence in the central bank’s resolve to reach its 2% target. Given that inflation will almost certainly overshoot the Fed’s target for the fifth consecutive year (even the FOMC doesn’t see it falling to 2% until 2028), one can’t dismiss the possibility that expectations will rise — as long-term measures have already done in both the New York Fed and University of Michigan consumer sentiment surveys. 

The Fed should signal that it isn’t likely to cut rates as far or as fast as financial markets expect. This would put it in a much better position to achieve its inflation and employment goals.