MNI INTERVIEW: Fed Could Cut More Than SEP Anticipates-Evans

The Federal Reserve might need to cut interest rates by more than officials indicated this week in the December SEP because holding steady amid further expected drops in inflation would make policy more restrictive, former Chicago Fed President Charles Evans told MNI.

“As you think about next year, the setting of monetary policy is well into restrictive territory, and with inflation improving, the SEP foreseeing core PCE at the end of next year at 2.4%,” Evans said in an interview Friday. "That’s tremendous progress."

"That means that any fixed setting of the nominal funds rate is going to get more and more restrictive if you don’t make adjustments," said Evans, who led the Chicago Fed from 2007 until his retirement earlier this year.

The FOMC left interest rates on hold for a third consecutive meeting this week and the median official penciled in 75 basis points of cuts for 2024. Markets are more ebullient about the prospect for looser policy, rallying across assets as investors price in as many as six cuts.

“It’s not surprising that the first take on rate cuts this close to 2024 is only three and then when you get to next December it could be that they do much, much more,” he said. (See: MNI INTERVIEW: Fed Could Cut Rates As Early As March-Hoenig)

TAYLOR RULES

The Fed expects inflation to improve by around a full percentage point between now and the end of next year, Evans noted.

“That’s worth a lot in terms of rate cuts according to most Taylor rules. That’s why I think markets are pricing in scope for further rate cuts,” he said. “There are plans and then there’s reality.” (See: MNI INTERVIEW: Five Fed Cuts In 2024 Are 'Plausible'-Wilcox)

He said a median SEP of three cuts would simply maintain a quite restrictive setting even as the economy softens.

“It takes more rate cuts along the lines of what’s priced in markets right now in order to move that down a little bit more towards neutral,” he said.

Even so, reducing nominal rates in order to keep real rates more or less constant could still result in a more tentative pace of rate cuts than past monetary easings that came with more weakness in the economy.

“Relative to past cycles it would be much more measured because past cycles are almost always a reaction to a deteriorating economic outlook,” he said.

This scenario today assumes the economy remains fairly robust and unemployment does not rise significantly, as the Fed SEP implies.

“I have pretty decent confidence that the economy is going to continue to be reasonably good,” Evans said. “There seems to be a lot of resilience in the economy.”

GETTING CLOSER

One key matter of debate is just how close to 2% the Fed needs to get. “They’re always going to be worried about getting inflation all the way to 2% even when a lot of other people in markets are saying 2.5% looks pretty good,” he said.

“Tensions are probably going to be in the last mile and how much confidence they have then. They have more confidence that the worst of the inflation is indeed behind us and we’re probably headed to below 3% PCE inflation before too long.”

Evans said adopting a higher inflation target could be beneficial in theory but unlikely in practice because central bankers tend to be conservative about making major shifts.

“If you were starting fresh, and you didn’t have all the restrictions all other central banks are at 2% and you understood the limitations of the zero lower bound, you could certainly support 3 or even 4% really,” he said. “If you always hit 3% steady year after year, wages would reflect that, interest rates would reflect that. It’s really the volatility that really hurts everyone.”