By Jamie McGeever
ORLANDO, Florida (Reuters) – U.S. interest rate cycles are driven largely by how restrictive or accommodative the Federal Reserve thinks monetary policy is. And right now, the picture is confusing.
After the Fed kept rates steady on Wednesday, Chair Jerome Powell said policy is still “meaningfully” restrictive, even after 100 basis points of cuts. But he also said that financial conditions are “probably still somewhat accommodative”.
So which is it?
To quote Powell again, it’s probably “a mixed bag”.
Highlighting both views serves a purpose. It affords the Fed some breathing room and helps justify what is likely to be a lengthy pause in the cutting cycle. And with so much uncertainty swirling around the potentially inflationary impact of President Donald Trump’s tariff and immigration agenda, more breathing room is good.
With the Fed in no “hurry” to resume cutting rates, as Powell said, a ‘wait-and-see’ period may also be good for financial markets. But the conflicting signals are potentially unnerving.
Theoretically, policy is still very much in ‘restrictive’ territory. The fed funds rate target range is 4.25-4.50%, well above the Fed’s median estimate of the long-run policy rate of 3.0%.
The ‘real’ policy rate adjusted for inflation is high too, above 2% by some measures. That’s high relative to recent history and well above the Fed’s 0.7%-1.2% estimates of ‘R-Star’, the nebulous real rate of interest in an economy at full strength with inflation stable at 2%.
David Zervos, chief strategist at Jefferies, argues that if you take into account the $2 trillion reduction in the Fed’s balance sheet since 2022, policy is the most restrictive it’s been in three or four years.
And with inflation expectations anchored, there’s plenty room for the Fed to cut rates.
“They did a killer job. Jay nailed it,” he told a conference in Miami on Tuesday.
STILL TOO LOOSE
Inflation hawks, on the other hand, argue that policy needs to be more restrictive and remain so as long as inflation is above 2%. Price pressures have cooled but annual inflation has been above the Fed’s target – measured by CPI or PCE inflation, headline or core – for nearly four years. And growth is humming along nicely, supported by strong domestic demand and a robust labor market.
For this crowd, if inflation is above target policy simply isn’t restrictive enough. Several measures of financial conditions suggest they could have a point.
Wall Street is hovering around its all-time highs, notwithstanding this week’s AI-triggered tremors, and equity valuations are historically elevated. High yield corporate bond spreads are the tightest since 2007 and close to the tightest on record, while bitcoin is probing fresh highs above $100,000.
These are hardly signs that policy is curtailing investors’ animal spirits or squeezing market liquidity. Indeed, the Chicago Fed’s national financial conditions index (NFCI) is the lowest since October 2021, close to the lowest in over a decade.
Of the 105 series used to construct the NFCI, 102 are looser than average, the Chicago Fed notes.
Little wonder then that investors are now expecting only a couple more rate cuts in this cycle, despite the fact that policymakers’ median forecasts point to a further 100 bps of easing this year and another 50 bps next year.
Economists at BNP Paribas reckon the Fed will remain on hold through mid-2026, as tariffs, tighter immigration policy, and easy fiscal policy lift inflation this year. But like the Fed, these economists are giving themselves some breathing room.
“We believe monetary policy is only slightly restrictive, and see two-way, roughly balanced risks going forward, with cuts possible if tariffs are smaller than expected, and hikes possible if a soft landing moves out of reach,” they wrote on Wednesday.
In other words, it could go either way.
Investors can be forgiven for being slightly confused about the Fed’s path forward, which means markets are likely to remain highly sensitive to every new economic data point or nuanced shift in Fed-speak over the coming months.
Which is to say, the one certainty in the coming months may be nervy markets.
(The opinions expressed here are those of the author, a columnist for Reuters.)
(By Jamie McGeever; Editing by Muralikumar Anantharaman)
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