The Federal Reserve Board of Governors: The Fed should immediately cut interest rates by 25 basis points. Here are my reasons.

Source: Speech by The Federal Reserve Board of Governors Christopher J. Waller; Translated by AIMan@Golden Finance

Tonight, my purpose is to explain why I believe the Federal Open Market Committee (FOMC) should lower the policy interest rate by 25 basis points at the next meeting (the July interest rate meeting). In the past, I often told my junior research colleagues that a speech is not a murder mystery - as long as the key points are made clear in advance, the audience can understand "who did it." So, let me also follow my own advice and outline the reasons I believe we should lower the policy interest rate in advance of the meeting in two weeks.

First of all, tariffs are one-time price level increases that will not lead to inflation beyond temporary spikes. The standard practice of the central bank is to "ignore" such price level effects as long as inflation expectations are stabilized, and indeed this is the case.

Secondly, a large amount of data indicates that monetary policy should be close to neutral rather than tightening. The actual GDP growth rate for the first half of this year may be around 1%, and it is expected to remain weak for the remainder of 2025, far below the median of long-term GDP growth estimates by members of the Federal Open Market Committee (FOMC). Meanwhile, the unemployment rate is at 4.1%, close to the committee's long-term estimate; if we disregard what I believe to be only temporary tariff effects, the overall inflation rate is slightly above 2%, close to our target. Overall, these data suggest that the policy interest rate should be close to neutral levels, with the median estimated by FOMC members being 3%, rather than our current level—1.25 to 1.50 percentage points above 3%.

The last reason I support a rate cut now is that although the labor market appears to be strong on the surface, once we take into account the expected data revisions, employment growth in the private sector is nearing a standstill, and other data suggest that the downside risks to the labor market have increased. Given that inflation is close to the target and the upside risks to inflation are limited, we should not wait for the labor market to deteriorate before lowering the policy rate.

Let me first explain my reasoning from my perspective on economic activity. Given the fluctuations in monthly GDP indicators this year, it is best to combine the data from the first and second quarters to better understand economic performance. According to existing data, estimates show that the year-on-year growth rate of real GDP for the first half of this year is about 1%, while it is projected to be 2.8% for the second half of 2024. This comparison is important not only because the degree of economic slowdown is quite significant, but also because it is well below most estimates of the potential growth rate of the economy. Based on leading indicators, I do not expect a rebound in the second half of the year—in fact, most forecasts indicate that the year-on-year growth rate of real GDP will remain around 1%. While recent tax legislation includes many factors to stimulate future economic growth, these effects will not manifest significantly this year.

The slowdown in GDP is significantly reflected in consumer spending, which accounts for about two-thirds of economic activity. Following a hovering around 3% last year, the growth rate of real Personal Consumption Expenditures (PCE) is expected to have dropped to 1% in the first half of this year. This morning, the U.S. Department of Commerce released retail sales data for June. Due to weak data in previous months, the growth in retail sales in June was in line with expectations. Looking ahead to this year, consumer spending is expected to continue growing at a similar pace, but the temporary effects of tariff increases will lead to a slowdown in the growth of real disposable income. I will discuss tariff issues more when talking about inflation, but when assessing recent economic momentum, tariffs are likely to be a factor.

When it comes to "soft" data, this picture of declining momentum is consistent with what I've heard from my business contacts and other sources. The Federal Reserve's Beige Book report released on July 16 indicates that economic activity across the various Federal Reserve districts is mixed, with five districts reporting slight or moderate growth, while the remaining seven districts are flat or declining. The results of the purchasing managers' survey also show signs of this mixed picture, with manufacturing continuing to contract and non-manufacturing activity expanding slightly. Given that businesses outside of manufacturing account for the vast majority of all businesses, this suggests that economic activity is expanding slightly.

Now let's talk about the labor market. The overall data from the June employment report looks reassuring—the unemployment rate is at 4.1%, within the range of the past year; jobs increased by 147,000, nearly unchanged from May. However, upon deeper analysis, I found some concerning reasons. Half of the new jobs came from state and local governments, and as we know, at this time of year, employment in this sector is difficult to seasonally adjust. In contrast, private sector jobs only increased by 74,000, a much smaller increase than in the previous two months, which is consistent with other survey results you may have read that found a decline in private sector jobs. I focus on private sector employment not only because it accounts for the largest share of employment but also because it reflects cyclical changes in employment better than combining public and private sectors. As I have told my students in the past, the Fed's responsibility should be to maximize private sector employment, not government employment.

There is another reason for the slowdown in private sector hiring. Recent patterns in data revisions suggest that wage data in the private sector has been overestimated, and these figures will be significantly adjusted downward during the benchmark revision in early 2026. Considering the expected revisions to employment levels in March 2025, it can be inferred that last month's job growth in the private sector was much closer to zero. This is why I say that wage growth in the private sector has approached a standstill and is flashing red lights.

I know this is just a month's data, and a possible factor for the slowdown in private sector hiring could be the decrease in net immigration this year, although it will take time to clearly understand how immigration affects employment. But other data also supports the view of a hiring slowdown. The media widely reports on the difficulties recent college graduates face in job hunting; in fact, the unemployment rate for recent graduates has reached its highest level in a decade, well above pre-pandemic levels.

Looking at both soft and hard data, I see a precarious picture of the labor market. Job vacancy and labor turnover survey reports indicate that the layoff rate continues to decline, but the hiring rate is also sluggish. I suspect this is a lingering effect of the tight labor market post-pandemic, with employers worried about a potential labor shortage re-emerging and unwilling to lay off qualified workers. Even so, purchasing managers are also reporting a cautious attitude, with some even pausing hiring. The Beige Book released on June 4 shows that labor demand in every Federal Reserve district is declining, and the Beige Book released on July 16 emphasizes that labor demand in many industries is still below supply. As hiring demand is already quite low, to a certain extent, the decline in demand will overwhelm any instincts to retain employees. If this attitude really shifts, it could mean a larger and more sudden reduction in job positions and an increase in the unemployment rate.

In summary, I believe the hard and soft data of economic activity and the labor market are consistent: the economy is still growing, but its growth momentum has significantly slowed, and the risks faced by the Federal Open Market Committee's employment mandate have increased.

Let's take a look at the inflation data. Over the past two days, we released the Consumer Price Index (CPI) and Producer Price Index (PPI) for June, which allow us to understand the inflation rate based on the Personal Consumption Expenditures (PCE) benchmark set by the Federal Open Market Committee (FOMC). After several months of adjustments, the 12-month inflation rate is much closer to the FOMC's target, with the CPI and PPI indicating that the overall PCE inflation rate rose to around 2.5% in June, and the core inflation rate also increased to about 2.7%. I believe this data reflects some moderate effects from the tariff increases that began in February, and I think tariffs will further push up inflation later this year. However, it is important to note that there remains a great deal of uncertainty about how trade agreements or escalations in trade conflicts will impact inflation outcomes.

To understand how tariffs affect prices, I not only focus on the monthly data from the U.S. Bureau of Labor Statistics but also on the research of high-frequency price data. For example, this year some researchers are tracking the short-term impact of tariffs on commodity prices in real-time by analyzing product-level price data from the online stores of large U.S. retailers. They found that, as of mid-July, the net prices of imported goods have increased slightly, while domestic goods prices have remained almost unchanged. Across all countries of origin, the price increase of imported goods from China has been the most consistently stable. However, so far, the data shows that the increase in commodity prices is very small relative to the magnitude of the tariff rates.

This finding is consistent with my view that most of the tariff increase will not be passed on to consumers. My long-standing assumption has been that consumers will have to bear about one-third of the price increase caused by the tariff hike, while the remaining portion will be shared by foreign suppliers and U.S. importers. Therefore, if import tariffs are permanently raised by about 10%, I expect this will lead to a 0.3 percentage point increase in the Personal Consumption Expenditures (PCE) inflation rate this year, and this upward trend is expected to gradually dissipate over the next year.

I can think of a few other possible reasons that may limit the impact on consumers. First, the pace of many tariffs being implemented has slowed down, having been delayed multiple times due to ongoing negotiations, which may give U.S. importers time to substitute domestic suppliers or foreign suppliers affected by lower tariffs with finished goods or intermediate products. Second, in the face of the economic slowdown I described and the potential pressure tariffs may place on consumer spending, foreign manufacturers and importers may be finding ways to control prices to maintain their presence on store shelves and retain customers. In fact, the slowdown in demand has intensified competition among all businesses, which may benefit consumers. Finally, although there has been extensive discussion about supply chain disruptions, the impact of tariffs on the supply chain is entirely different from the situation during the pandemic. During the pandemic, the supply chain was effectively disrupted: many workers were out of work, factories were idle, and waves of COVID-19 hit globally at asynchronous times. In contrast, with increased tariffs, we clearly know the origin of products, and there are no issues—businesses are simply arguing over prices and who will bear the tariffs. Once these issues are resolved, goods will naturally flow globally, but possibly via different routes.

Of course, the impact of tariffs on inflation may be greater than I expected, but this will not affect my view on their impact on monetary policy. As I have emphasized multiple times, raising tariffs is just a one-time increase in prices and cannot sustain a rise in inflation. In the absence of a disanchoring of inflation expectations and accelerating wage growth (which we have not yet seen), tariffs will not and cannot permanently raise the inflation rate. What does this mean for monetary policy? Research shows that central bank governors should - and indeed do - carefully examine price level shocks to avoid unnecessarily tightening policy during the current period, which would harm the economy.

The key issue in monetary policy right now is how we can assess the potential inflation rate based on economic fundamentals – that is, the inflation rate excluding tariffs. Staff at the Federal Reserve Board of Governors have begun working to estimate the impact of tariffs on Personal Consumption Expenditures (PCE) prices. Using this method, if I subtract the estimated tariff effects from the reported inflation data, I find that the inflation numbers over the past few months should be very close to our 2% target. You won't hear me say "mission accomplished", but this tells me that underlying inflation is below the reported level and is close to our target.

Aside from tariffs, I do not expect other factors to lead to an undesirable sustained rise in inflation. One reason is that the growth rate of labor compensation has significantly decreased over the past year or two, and with a weak labor market, I do not expect workers to receive substantial pay increases in the future. Coupled with stable productivity growth, the inflation rate should remain around 2%.

In addition, two points support my inflation outlook, which I have discussed in detail in my June outlook speech, so I will only summarize here. The first question is whether I will make the same mistake as I and my colleagues at the Federal Open Market Committee (FOMC) made in 2021 and 2022, which was to expect that the rise in inflation was only temporary, but it turned out to be persistent. However, unlike that time, there is currently no pandemic disrupting the supply of global labor, goods, and services; the economy is currently slowing down rather than rapidly expanding. These differences lead to my second point, which is that unlike the rise in future inflation expectations in 2021 and 2022, the inflation expectation indicators I am focused on today remain solid.

In summary, tariffs have already pushed inflation rates higher and will continue to do so, keeping them slightly above the Federal Open Market Committee's 2% target for this year. However, policy should ignore the impact of tariffs and focus on the underlying inflation rate, which seems to be close to the Federal Open Market Committee's 2% target. I do not believe there are any factors that will continue to drive inflation rates higher.

I hope everyone can see clearly now that the evidence of economic slowdown, along with all the factors affecting economic activity that I mentioned earlier, indicates that the risks to the employment goals of the Federal Open Market Committee (FOMC) are greater, enough to prompt a shift in its monetary policy stance. According to the economic projections summary from June, the current target range for the federal funds rate is 4.5% to 4.5%, which is 125 to 150 basis points higher than participants' median estimate of a long-term federal funds rate of 3%. While I sometimes hear people say that policy is only moderately restrictive, that is not my definition of "moderate."

In fact, there is still a long way to go before reaching a neutral policy setting, which seriously affects my judgment on whether I should move in that direction again. In June of this year, most FOMC members believed that a reduction in policy interest rates at least twice in 2025 is appropriate, and there are still four meetings left now. I also believe— I hope my point of view is convincing— that the risks facing the economy tend to favor an early rate cut. If the slowdown in economic and employment growth accelerates and a quicker shift to a more neutral policy setting is needed, then waiting until September or even later this year, we may fall behind the appropriate policy curve. However, if we lower the target range in July, and subsequent employment and inflation data indicate fewer rate cuts, we can choose to maintain policy stability in one or more meetings.

Therefore, I think it is reasonable to lower the policy interest rate of the Federal Open Market Committee by 25 basis points in two weeks. Looking ahead to later this year, if, as I expect, the core inflation rate remains under control – overall inflation data shows that the inflation expectations brought about by tariffs have risen moderately and temporarily, and will not affect inflation expectations – and the economy continues to grow slowly, I would support a further reduction of 25 basis points to bring monetary policy towards neutral.