MNI INTERVIEW: Fed To Wait For Sept Despite Jitters-Stein

MNI (WASHINGTON) - The Federal Reserve looks set to begin lowering interest rates in September and will probably do so gradually as it balances signs of softness in the labor market with sticky inflation, former Fed board governor Jeremy Stein told MNI. 

Speculation about a possible emergency reduction in borrowing costs is overdone, especially as it was based on a single weaker-than expected employment report, Stein said. 

“The market may be overreacting in terms of how much they’ve accelerated the implied rate of Fed cutting. I think an intermeeting move is a stretch – one saves that for very serious circumstances,” the Harvard University economics professor said in the latest episode of MNI’s FedSpeak Podcast.

“By now a September cut seems absolutely baked in. I wouldn’t be surprised if there are a few more after that.” 

GRADUAL BUT NIMBLE

Stein said the Fed would prefer to be gradual in reducing interest rates, though that did not rule out larger cuts if needed. (See MNI INTERVIEW: Fed To Cut Gradually If Growth Solid-Giannoni)

“The folks at the Fed will say well, we’ve had one bad report. The signal to noise of one report is not all that high, so it’s going to depend a lot on whether the next two or three confirm or push back a little bit on what we’ve seen," he said.

“If you’re the Fed, absent fairly dramatic labor market moves, I think you want to proceed cautiously and keep your eye on the data. Whether they go 50 basis points or not has yet to be determined. I don’t think anybody can prejudge that."

Investors have sharply boosted their expectations for cuts this year since last week's softer payrolls and a rise in the jobless rate to 4.3%. Futures markets are pricing in as much as 130 basis points of cuts by January – implying multiple 50bp moves. Stock markets fell sharply first in Japan then around the world Monday, but have since recovered their footing.  

KEEPING COOL 

Stein said it’s important to resist the temptation to interpret every big market move as a major shift in the economic outlook. 

“It’s dramatic, and it comes on the heels of a worse-than-expected jobs report. Does it mean a recession is coming? Not necessarily. Surely there wasn’t as much fundamental news in that report as one might think from looking at the magnitude of the market moves.” 

Still, inflation has made remarkable progress even if it's still short of the 2% target, and the employment picture is getting murkier, so “we’re probably at a point where the two legs of the mandate suggests you want to be closer to neutral," Stein said.

THERMOSTAT WITH NO NUMBERS 

The problem is that no one quite knows where that is, he added. “It’s a little bit like adjusting a thermostat that has no numbers on it. There’ll be a process of gradually feeling their way.” 

For Stein, the neutral rate, also known as R-star, is likely higher than most Fed officials believe. That means policy is not as restrictive as many FOMC members believe, but also that the central bank isn’t as far away from neutral as critics who worry policymakers are behind the curve have been arguing. 

“I think it’s probably significantly higher than it was in the years leading up to the pandemic. I could certainly imagine that it’s closer to 2% real or 4% nominal so that we don’t really have all that long a ways to go,” Stein said. The Fed’s long-run median projection estimate neutral at 2.8%, up from 2.6% previously but still implying a quite restrictive stance with fed funds at 5.25-5.5%.