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For the past nine months, the US Federal Reserve has sat on its hands much to the chagrin of US President Trump. Many Republicans have been frustrated with the Fed, particularly following the outsized 50bp cut last September which some construed as providing a boost to Democrats in the run up to the 2024 Presidential Election.
With Powell not lowering rates since Trump has come into office, the US President has publicly attacked the independent central bank. President Trump has expressed a clear desire to fire Chair Powell, his own appointment during his first term, but has lacked a legal standing to remove him from the Fed. Nonetheless, Trump will certainly replace his nicknamed “Too late Powell” as Fed Chair when his term expires in May 2026.
Not stopping there in his attack on the Fed, the President has more recently gone after the Democrat-appointed Fed Governor Lisa Cook for mortgage fraud. A US District Judge this week granted an injunction blocking Cook’s firing while the dispute is heard in the courts. This means that Cook will remain on the FOMC during next week’s meeting unless Trump’s team manages to win an appeal in the next few days. Another Biden-appointed Fed Governor Adriana Kugler resigned from the Fed Board last month, five months ahead of the expiry of her term. President Trump has nominated Stephen Miran, the Chair of his Council of Economic Advisors to fill the position and is attempting to rush his confirmation through Congress. However, it remains unclear whether the process will be finalised ahead of the Fed meeting next week.
From an economist’s perspective, President Trump’s attack on the independence of the US Federal Reserve is concerning. Independent central banks have a far better track record of achieving low and stable inflation. This credibility and a clear mandate on price stability is key for keeping inflation expectations well anchored. A politically influenced central bank is far more likely to tolerate higher inflation in order to achieve other goals, such as faster economic growth and lower unemployment. Once the hard-fought inflation credibility is lost, the ability of a central bank to keep inflation low and stable becomes far more difficult. Academic evidence is clear that an independent central bank benefits the long-run welfare of a country.
Notwithstanding the political pressure, what should the US Federal Reserve do next week? The Fed is in an unenviable position for any central bank. Inflation is above target and rising due to the impact of higher tariffs. The CPI data this week is consistent with the Fed’s preferred core PCE inflation rate remaining around 2.9% in August, up from 2.6% in April. Employment is also starting to disappoint. Non-farm payrolls rose just 29,000 per month over the three months to August, while preliminary benchmark revisions suggest 911,000 fewer jobs over the year to March than previously thought. The unemployment rate is moving higher, rising to 4.3% in August, up from 4% in January. In other words, the Fed faces a trade-off with both elements of its dual mandate of maximum employment and price stability moving in the wrong direction.
In times like these, we are advocates for a rules-based approach to monetary policy. They can help to weigh the trade-offs between maximum employment and price stability. They can also help in communication and preserve central bank credibility.
Perhaps the most well-known rule for monetary policy is the Taylor rule. Under the Fed’s preferred specification of the Taylor rule, the interest rate should be set at the real neutral interest rate plus the inflation rate (core) plus half the inflation gap (i.e. difference between the inflation rate and the 2% target) plus the unemployment gap (i.e. the difference between the long-run unemployment rate/NAIRU and the current unemployment rate).
Let’s look at what such a rule would imply for an appropriate Fed funds rate today. In its June forecasts, the Fed assumed a neutral real rate of 1%. The current core PCE inflation rate is 2.9%, implying an inflation gap of 0.9%. The current unemployment rate is 4.3%, compared to the Fed’s long-run view of 4.2%, leaving an unemployment gap of -0.1%. Plugging these values into the Taylor rule suggests an appropriate Fed funds rate of 4.25%, which is 12.5bps below the current rate of 4.375%. In other words, based on current economic data, a Taylor rule would be split 50/50 between cutting rates or remaining on-hold.
However, given the lags in monetary policy transmission to the real economy, central banks conduct monetary policy in a forward-looking manner in what is often referred to as a forecast-targeting approach. In other words, where do we need to set interest rates to best achieve our goals over the next 1-2 years? Obviously, this is where more discretion comes into the monetary policy decision making process, especially once central banks also start to consider the different balance of risks. Nonetheless, if we take an average of the Fed’s latest forecasts for the end of 2025 and 2026, where core PCE inflation was expected to average 2.75% and the unemployment rate was lifting to 4.5%, a Taylor rule would advocate for interest rates to be around 3.825%, justifying two cuts in coming months.
This simple Taylor rule analysis is all based on the Fed’s economic projections from June. Given the recent data flow, we suspect the Fed may increase its unemployment rate forecast in its new projections to be released next week, but we wouldn’t expect much change to their inflation forecasts. If we were to see the Fed lift its unemployment rate forecast to 4.7%, the Fed could appropriately shift towards expecting three rate cuts this year. The rationale for cutting rates next week has become clear according to a transparent, rules-based approach. There is no need for political interference.
