The high political stakes of Fed interest-rate cuts

Stipulate that Federal Reserve Chairman Jerome Powell isn’t trying to throw the Fed behind one candidate or another in November’s presidential election. There’s still political danger for Mr. Powell and the central bank lurking in the September interest-rate cut Fed officials are priming investors to expect.

Mr. Powell on Wednesday delivered the strongest signals yet that a quarter-point rate cut may be coming in September, and investors hope for a total of three cuts before the end of the year. Unlike previous episodes of irrational rate-cut exuberance (remember when Wall Street thought we’d get six reductions this year?), this prediction may come true. Inflation finally appears to be drifting toward the central bank’s 2% target, allowing the Fed to declare victory.

Meanwhile, there are some signs the economy is softening despite healthy economic growth in recent quarters. The unemployment rate, while still low by historical standards, is drifting upward. Mr. Powell on Wednesday suggested such developments again are on the Fed’s radar as it weighs future policy moves.

The political problem for the Fed is that translating these general observations into specific policy decisions isn’t straightforward.

This is an important transition point for the central bank. Since early 2022, the Fed has taken the moderation of price rises to be its only job. It could hardly do otherwise amid the worst inflation in 40 years. In theory this task was simple if not always easy, since the single target is observable in monthly data. And yet the central bank still found itself mired in controversy. Economists debate what caused the inflation and whether the Fed has deployed the correct tools to control it, while the general public complains that official measures of inflation don’t accurately represent the price changes households experience day to day.

Now that inflation appears to be abating, the central bank will revert to a far more complex task: balancing predicted future inflation against predicted future economic growth. This is why, for instance, Mr. Powell might contemplate a modest rate cut before inflation has slowed all the way to 2%. The central bank will present this as a technocratic matter of making estimates about the economy’s trajectory and adapting policy in line with those predictions.

But if you want to see into the future you need a crystal ball. Officials make these policy trade-offs on the basis of predictions generated by the Fed’s economic models. These are essentially the spreadsheets that estimate how changes to this or that variable will affect inflation, growth, employment and other outcomes. If the past few years have taught us anything, it’s that the Fed’s crystal ball is badly cracked.

The central bank didn’t predict the inflation that started to arrive in earnest in early 2021 and didn’t predict how durable it would be. The Fed’s models seem to misunderstand the relationship between unemployment and inflation (if there is one), overestimate the importance of households’ and businesses’ expectations of future inflation, inadequately account for fiscal policy, and more. These errors have necessitated several embarrassing climb-downs for Mr. Powell, as when this spring he had to delay rate cuts that officials previously had predicted—on the basis of the Fed’s economic models—could have started sooner.

In extremis, Mr. Powell’s solution to this problem was to politicize monetary policy in the best sense of that word: the use of honest intuition to navigate an uncertain situation in pursuit of an outcome tolerable to the largest number of people. His intuition told him that it’s important for the economy and the Fed’s institutional credibility that he err on the side of hawkishness, no matter the models.

This was the right approach, but it creates challenges for Mr. Powell now. Having previously abandoned Fed models in favor of “data dependent” policymaking, he needs to explain on what basis the central bank is returning to its faulty models to make a judgment that September will or won’t be the time to start reducing interest rates in order to avert future economic ills.

Political pressure comes from both sides. Donald Trump warned Mr. Powell in an interview with Bloomberg Businessweek published in July not to cut rates before the election for fear such a move might help the Democrats. On the other side, Mr. Powell has goaded investors to bid up asset prices in expectation of a September rate cut, and Democrats will seethe if his failure to deliver produces a pre-election market tumble.

This isn’t a dilemma entirely of Mr. Powell’s making. His predecessors failed to improve the central bank’s economic models even as they significantly increased the Fed’s role in the economy. But he has compounded those errors, first by lobbying in 2020 for the sort of government spending that has proved inflationary, and then by taking too seriously his staff’s estimates that inflation would prove “transitory.”

As Mr. Powell’s Fed transitions—in September or soon after—out of inflation-hawk mode, his next challenge will be to reassure the public that the central bank remains an independent, technocratic institution.