Former Fed "Old Leader": It's time for a big move, a 50 basis point rate cut is reasonable, believe Powell will do so

Former Federal Reserve Vice Chairman and ex-New York Fed President Dudley said on Monday that the Fed faces a key decision at this week's meeting: whether to make a modest 25 basis point rate cut or to directly cut rates by 50 basis points to curb a U.S. economic recession.

Dudley reiterated what he pointed out at the Bretton Woods Committee meeting in Singapore last Friday - the logic of a 50 basis point rate cut is more convincing. "I think, whether they (the Fed) cut rates or not, there are sufficient reasons for a 50 basis point cut."

Dudley's latest statement indicates that he believes Fed Chairman Powell supports taking aggressive action. Powell specifically mentioned last month that further softening in the labor market is unwelcome, and now the employment market does seem to be further deteriorating. In addition, monetary policy is in a tightening stance when it should be neutral or accommodative. A larger rate cut can align the Fed's dot plot projections with market expectations, while a 25 basis point cut is an unexpected move that is not supported by economic prospects and would disappoint the market.

Dudley's column on Bloomberg

The Federal Reserve faces a crucial decision at this week's policy meeting: whether to slightly ease monetary policy with a 25 basis point rate cut, or to rarely cut rates by 50 basis points to ward off an economic recession.

What should the Fed do? And what will it do? The answers to these two questions may not necessarily be the same. But this time, I believe the answers will be the same.

A series of news reports have fueled market expectations for a larger rate cut, significantly intensifying the tension over the choice between a 25 basis point cut and a 50 basis point cut. As I pointed out at the Bretton Woods Committee meeting in Singapore last Friday, the logic supporting a 50 basis point rate cut is convincing.

The Fed's dual mandate of stable prices and maximum sustainable employment has become more balanced, indicating that monetary policy should be neutral, neither restraining nor promoting economic activity. However, short-term interest rates are still far above the neutral rate and this gap needs to be corrected quickly.

Consider the economic data. The unemployment rate has risen by 0.8 percentage points from its low in January 2023. Over the past three months, the pace of nonfarm payroll growth has been the slowest since 2020. Wage inflation has slowed to below 4%, while the Fed's preferred consumer price inflation measure is around 2.5%. Although core consumer prices rose slightly more than expected in August, this was driven by categories that are typically lagging (insurance and housing), and the latest producer price report suggests that core personal consumption expenditure index will be quite moderate.

One could even argue that the downside risk to employment outweighs the upside risk to inflation. When the labor market deteriorates to a certain extent, this process often becomes self-reinforcing. Whenever the three-month average unemployment rate rises by more than 0.5% from its previous 12-month low, the end result is a larger increase in unemployment - at least 1.9 percentage points, and an economic recession. Given that the rise in the unemployment rate is mainly driven by rapid labor force growth, the threshold this time may be higher. But this does not negate the idea of a critical point, and the notion that the labor market has crossed or is approaching a critical point A 50 basis point rate cut also aligns very well with the latest economic forecasts to be released by Federal Reserve officials this week. The market expects the Fed to cut rates by at least 100 basis points by the end of 2024. If the Fed were to cut rates by only 25 basis points now and signal further cuts of 50 basis points at the next two meetings later this year, it would send a hawkish signal. If the Fed were to cut rates by 25 basis points now and signal cuts of more than 50 basis points later in the year, people would wonder why the Fed didn't cut rates immediately. Therefore, a larger rate cut would help the Fed navigate this complex situation.

So, why might the Fed not cut rates by 50 basis points? Here is the best explanation I can think of:

• First, the expected target for short-term rates is much more important than the speed of rate cuts. Expectations drive long-term rates, including mortgage rates. Given the expectation of a total cut of about 250 basis points by the end of 2025, the rate cut this week should not have a significant impact.
• Second, the Fed wants to ensure that it has already defeated inflation. The Fed has been fooled before: earlier this year, inflation rebounded, forcing the Fed to maintain high rates for a longer period. Fed Chair Powell does not want to repeat the mistake of former Fed Chair Arthur Burns, who failed to keep inflation in check in the 1970s.
• Third, despite a slowdown in the U.S. economy and some weakness in the labor market, there are hardly any signs that it is in or near a recession. The Atlanta Fed's GDPNow model predicts an annualized growth rate of 2.5% for this quarter after adjusting for inflation.
• Finally, a smaller rate cut may prevent Trump from complaining that the Fed is boosting the economy to improve Harris's election prospects. Fed officials probably prefer to stay as far away as possible from this year's election politics.

Nevertheless, I expect the Fed to adopt a 50 basis point rate cut policy. I believe Chairman Powell is inclined to take an aggressive approach: in his speech at the Jackson Hole Global Central Bank Conference last month, he pointed out that further weakness in the labor market, which seems to be occurring, would be "unwelcome." Monetary policy is tight when it should be neutral or even accommodative. By now taking a larger rate cut, the Fed is more likely to align its forecasts with market expectations rather than face unpleasant surprises that are at odds with economic prospects