The Case for Huge Fed Rate Cuts Up Front (And Maybe Some Hikes Later)

The goal should be getting to "neutral" as quickly as possible. Since no one knows where that is, optimal policy should consist of moving down quickly while preserving the option to correct later.

Federal Reserve officials believe that it is time to start lowering short-term interest rates. But they are unsure of how rapidly to do so, even though they told us in June that they broadly agree that short rates should drop by about 1.25 percentage points by the end of 2025 and by more than 2 percentage points by the end of 2026.

My suggestion: they should lower rates to their best estimate of “neutral” immediately, while remaining willing to raise rates rapidly again if that estimate turns out to be too low. This approach may lead to substantial interest rate volatility, but it also reduces the risk of meaningful policy errors. By contrast, the “gradualist” approach that seems to be most officials’ current preference is much more likely to lead to a mistake—in either direction.

The Problem With the Fed’s Current Plan

Central bankers are supposed to make sure that the cost of raising money is high enough to prevent excessive spending, but not so high as to prevent businesses and consumers from doing things that would make everyone better off.

Fed officials have been telling us that “monetary policy is restrictive” for years, and that they would move away from this policy stance as soon as they were confident that inflation was heading back to their 2% yearly goal, or as soon as the job market started to weaken. They are keen to begin lowering rates because they now believe that both conditions have been met, which means that it is time to move to a “neutral” stance.

However, Fed officials are unsure of just how much they should adjust policy. After all, nominal spending, inflation, and real growth have all been remarkably stable since the end of 2022. The latest nowcast from the Federal Reserve Bank of Atlanta implies that real gross domestic product is rising at a yearly rate of about 2.5% in 2024Q3, after rising at a 3% yearly rate in 2024Q2. While higher interest rates did discourage borrowing by households and businesses, there has been little obvious slowdown in consumption or capital investment. That suggests that rates may not actually have been as “restrictive” as implied by models calibrated on pre-pandemic data.

There are several potential explanations for this¹, but the implication is that the level of interest rates that does not cause the growth rate of overall spending to either accelerate or decelerate—what Fed officials call “neutral”—may have meaningfully increased. If that is what happened, then much of the rise in the level of interest rates since the end of 2021 could reflect a shift to “neutral”, rather than a “tightening” that “restricts” economic activity.

Alternatively, we are poised to re-enter the pre-pandemic world as soon as we finish working off the disruptions of the past few years. Getting to “neutral” from here could therefore mean anything from holding short rates where they are to lowering them all the way down to the pre-pandemic range of 1.5%-1.75%.

Fed officials are aware of this uncertainty, and their plan is to cross the river by touching the stones. Governor Christopher Waller, who has proven to be among the most influential monetary policymakers at the Fed, recently said that he is “open-minded about the size and pace of cuts”. But he also said that he did not want preemptively lower rates before the data have turned because is worried about “the risk of overshooting on rate cuts if the neutral rate has in fact risen above its pre-pandemic level.”

The problem is that this approach will work only if “neutral” is slightly below the current rate. While that is my current hypothesis, the latest data have made me somewhat less confident (more on that further down). If instead “neutral” is well below current levels, gradualism would guarantee that policy remains too tight for too long, and would therefore risk pushing a healthy economy into an unnecessary downturn.

Moreover, the risks are asymmetric. If rates go “too low”, they can always be raised again. But if rates are too high for too long, the resulting damage could be difficult to repair even if the Fed eventually responds as the textbooks recommend. The great reopening from the pandemic was the only time that the U.S. job market snapped back quickly from a drawdown. Normally, it takes many years for employment rates to fully recover even from “mild recessions”.

What to Do Instead

Given this, Fed officials could learn a trick from computer science and use binary search to get to “neutral”.²

If you have 12 hours of security camera footage and are trying to find the moment when thieves break into a store, the fastest way to narrow it down is to start in the middle. If the store has already been robbed, go back 50% to the beginning (3 hours in), or if not, move 50% closer to the end (9 hours in). Suppose you do this and find that the store was robbed sometime between hours 6 and 9. The next step is to go to hour 7.5—halfway between—and repeat the process. Pretty soon you will find the exact moment you are looking for, and all without having to stare at a screen for anything close to 12 hours.

Were the Fed to try something similar, it would be roughly equivalent to lowering the policy band to 3.25%-3.5% immediately, and then waiting to see what happens. That seems to be around where traders and Fed officials think “neutral” is. Futures market pricing implies that there is a ~74% chance that the Fed’s policy rate will be between 2.5% and 3.25% by September 2025, while the current implied yield on a 2-year U.S. Treasury note three years from now is about 3.4%.³ These prices could be wrong, of course, but they are broadly consistent with where Fed officials have said they eventually want to end up.

If the job market improves and other indicators stabilize, then the decision would have been sound. If instead we get a surge in new borrowing, asset inflation, and an acceleration in nominal spending that ends up flowing through to consumer prices, then we could infer that “neutral” is somewhere closer to current levels, and the Fed could correct the error by raising short rates up to ~4.5% in a single meeting, after which officials could reassess, and potentially raise rates further.

This approach is roughly the opposite of what Fed officials prefer to do outside of crises: move steadily in tiny increments over several years.⁴

But their own recent experience shows that there are few costs to moving more aggressively during periods of uncertainty about where rates need to go. After all, even if you believe that the Fed was “late” to raise interest rates in 2021-22⁵, once officials started the process they were willing to move quickly. It worked out so well that everyone is now talking about “normalizing” rates at some lower level even as the share of workers aged 25-54 hits new highs, real output is ripping, and bank lending is on its way back.

The rest of this note will look into why I am more sympathetic to a policy shift than I was before.

Why It Might Be Time To Lower Rates

There are many potential factors that can affect the optimal level of short-term interest rates at any point in time. But if inflation is stable—or slowing down—at the same time as the jobless rate is rising, it is usually a good signal that rates are too high.