The 30,000 foot view

What is the Fed looking at?

As expected by Macrosight, the CPI rate of inflation for August supported the “inflation is stable” trend of recent months. Now, pundits and markets are a flutter anticipating a 50 basis point interest rate cut next week (the Fed’s policy committee is meeting next Tuesday and Wednesday).

Why does a “stable” inflation rate provide a favorable omen with regard to a rate cut? Because the Fed’s job is “stabilization” policy. For them (and macroeconomists more generally), the hallmarks of a stable economy include (but is not necessarily limited to) the following:

1. The rate of inflation is close to the Fed’s inflation target of 2 percent. While currently the rate is above that, the month-to-month evolution of price increases has been consistent enough that the Fed may be satisfied that the “inflationary pressures” of 2022 - 2023 have finally abated.

2. The unemployment rate is close to the non-cyclical rate of unemployment. Even though the unemployment rate increased from 3.7 in January to its latest 4.2 percent, the rate is still below the “natural” or non-cyclical rate of unemployment.

3. Real GDP is close to Potential GDP. What does this mean? Let’s discuss.

The Potential GDP-Actual GDP Gap

In their quest to stabilize the economy, a key idea is that real GDP stays close to Potential GDP. The latter is the “golden” or stable level of real GDP, given the full and efficient employment of our people and resources (explained here by Macrosight). Figure 1 displays real GDP and Potential GDP since 1949.

Figure 1 shows Potential GDP out to 2034 (see, again, this post for details on Potential, including the source of the statistic).

As of the middle of this year, current real GDP equals about $22.9 trillion. Potential GDP is just below that at $22.7 trillion. Figure 2 shows a more focused look at the difference between two values.

This positive gap implies the U.S. economy is doing relatively well. In fact, the gap suggests the economy is running a bit hot.

However, the fact that the gap is “only” about $200 billion may imply that things are “good enough” for the Fed. Potential GDP, after all, is an estimate. That implies there is some upper and lower range for that estimate, with $200 billion representing the midpoint of that range. Hence, without getting into the statistical-weeds,¹ let’s assume that $200 billion our current level of real GDP—$22.9 trillion—is close enough to Potential to signal to the Fed that the economy is, in fact, “stable.”

If that is the case, then the Fed will feel emboldened to cut rates next week. However, if we see the Fed balk at cutting rates (or, say, “only” cut rates by 25 basis points), that would suggest the Fed still feels uneasy about that stability. With respect to the list of three things at the outset of this post that would imply the following:

1. The current rate of inflation still too high for their liking. If so, they may wait until later this fall to cut rates.

2. The labor market still too hot to suggest that the economy is stable enough. They might come to this conclusion since, as mentioned, the unemployment rate of 4.2 percent is still below the non-cyclical rate of unemployment.

3. And, they may view current real GDP too high relative to Potential GDP. While one might argue—as stated above—that $200 billion is close enough, grouped with the first two points, the Fed may feel “standing pat” is warranted.

Of course, we are a few days away from seeing what the Fed actually does. Many are eager for a cut, obviously. But based on the 30,000 foot-view it’s not a “slam dunk.”

1. If one wanted to get into the statistical-weeds, one could calculate the gap between real GDP and Potential for every quarter from 1949 through the second quarter of 2024. Then, one could assess the average gap size, and the range of the gap over all of those periods. That would provide a sense of how large a gap of $200 billion really is or is not, relative to the historical average. Once could go further, too, and calculate statistics such as z-scores for each quarter.