Michael Strain's Concerns About the Fed's Rate Cut

This week, as expected, the Federal Reserve announced a 25 basis point interest rate cut. Dot plots hinted at two more cuts this year, with expectations of further easing in 2026. However, after this cut, Michael R. Strain, director of economic policy studies at the American Enterprise Institute, expressed concern that the Fed's stance is too dovish and could cause them to have to raise interest rates again next year.

The Fed's decision to begin the monetary easing cycle this month is based on three main factors. First, the slowdown in overall job growth strongly suggests a weakening labor market. In the past three months, the US has averaged only 29,000 new jobs per month, and June saw a contraction in job numbers. Second, underlying inflation is gradually returning to the Fed's target level, although the process is slow. Third, there is a clear gap between the Fed's current policy rate and the rate that no longer constrains economic growth. The Fed estimates the so-called "neutral rate" to be 3%.

Strain's Objections to the Fed's Assessments

Strain argues that the Fed has misjudged these three points. Regarding jobs, he points out that new job data is difficult to interpret due to sudden fluctuations in the number of immigrants. The job increase needed to keep up with population growth may be less than 50,000 jobs per month, and there may even be the possibility of a negative job growth "break-even point" in the future due to changes in net immigration flows, meaning that a net decrease in jobs is needed to keep pace with population changes.

The US unemployment rate is typically the best indicator of how tight the labor market is. In August, it was 4.3%, a very low level, and it increased by only 10 basis points (0.10%) over the past year. Strain notes that the unemployment rate reflects changes in immigration in both the numerator and denominator.

Strain adds that wage growth is consistent with the message the unemployment rate is sending: solid growth, gradual cooling, suggesting that overall new job data more reflects changes in the labor supply side rather than companies' demand for labor.

If the labor market is deteriorating as significantly as the Fed claims, it would be accompanied by an increase in the number of layoffs. However, Strain points out that the number of monthly layoffs has remained stable over the past year, at approximately 1.8 million per month, roughly in line with the period when the labor market was booming in 2019.

Persistent Inflation Concerns

Regarding underlying inflation, Strain says he is more concerned than the Fed. Although the Fed underestimated the threat of inflation in 2021, aggressive action in 2022 caused underlying inflation to decline since the fall of that year. Core inflation, as measured by the Personal Consumption Expenditures (PCE) deflator, fell by about 3 percentage points from spring 2022 to spring 2024.

However, in the past year, core PCE inflation has almost stalled, falling by only 28 basis points (0.28%) from April 2024 to April 2025. Worryingly, core PCE inflation has actually risen this summer, reaching 2.9% in July, which Strain says is well above the Fed's target and heading in the wrong direction.

This acceleration in underlying inflation may be partly due to one-off price increases caused by tariff increases. But more importantly, consumer spending, the key driver of aggregate demand, remains strong. Retail sales in August grew by 5% year-on-year, far exceeding expectations.

This trend is also reflected in economic forecasts. Economists at Goldman Sachs expect the US economy to grow at an annualized rate of 2.5% this year, while data tracked by the Federal Reserve Bank of Atlanta shows growth of 3.3% this quarter. Both figures are above the economy's sustainable potential level, meaning there is upward pressure on prices.

Is the Neutral Rate Higher Than the Fed Thinks?

Strain believes that, looking at the labor market, price inflation, consumer spending and overall economic activity, the 4.4% federal funds rate is not significantly deterring consumers and businesses. In other words, the Fed's estimate of the neutral rate is wrong.

To fully restrain demand, the policy rate would appear to need to be above 4%. But the Fed plans to cut interest rates to 3.6% this year, and cut them further in 2026. Strain believes this could push inflation up faster in the context of a strong labor market.

Strain concludes that a general using old tactics to fight current battles may lose the current conflict. The Fed seems to still be looking back to the weak labor market after the 2008 financial crisis and the low neutral rate at that time. He says today's economic environment is completely different, and the Fed has not yet won this new battle against the resurgence of inflation.

In addition, continued threats from US President Trump regarding the Fed's political independence make the situation even more worrying. One FOMC member expects to cut interest rates five more times (for a total of 125 basis points) by the end of 2025, which would lower the federal funds rate to below 3%. Strain believes that if future Fed-appointed officials hold similar views, inflationary pressures could increase, raising the risk that the Fed will have to raise interest rates again next year.