More good news on the inflation front: disinflation continues apace. According to the latest data from the Bureau of Labor Statistics, the Consumer Price Index (CPI) grew at a continuously-compounding annual rate of 2.4 percent over the last twelve months, down from 2.6 percent in the prior month. Consumer prices grew at an annualized rate of 2.2 percent in September.

Core CPI inflation, which excludes food and energy prices, remains elevated. It grew at a continuously-compounding annual rate of 3.2 percent over the last 12 months, unchanged from the prior month. Core CPI grew at an annualized rate of 3.7 percent in September, and has averaged 3.0 percent over the last three months.

Moderate price growth suggests the Fed is close to its long-run 2.0 percent inflation target. Perhaps it’s already there. In either case, the FOMC made the right call when it cut its interest rate target by 50 basis points in September. Going forward, it should consider further cuts to prevent passive monetary tightening.

The current range for the federal funds rate target is 4.75 to 5.0 percent. Recall that the nominal interest rate is equal to the real interest rate plus expected inflation. Using the most recent monthly rate (2.2 percent) as a proxy for expected inflation yields a real interest rate range of 2.55 to 2.8 percent.

To judge the stance of monetary policy, we must compare the real interest rate target range to the natural rate of interest, i.e., the rate consistent with maximum sustainable production, minimal sustainable unemployment, and non-accelerating inflation. We do not directly observe the natural rate of interest. But the most recent estimates offered by the New York Fed put it somewhere between 0.74 percent and 1.22 percent. Hence, the real federal funds rate target range is much higher than the natural rate. It looks like there’s a 300 basis point difference. That’s a very large gap. Unless the models are totally unreliable, monetary policy remains tight.

Monetary data reinforce this narrative. In general, monetary policy may be described as loose if the money supply is growing faster than money demand, M2 is about 2.2 percent higher today than a year ago. The broader, liquidity-weighted monetary aggregates are up between 1.67 and 2.25 percent over the same period. 

As with the natural rate, we must estimate money demand growth. We can add real GDP growth and population growth to construct a reasonable proxy. The economy grew approximately 3.0 percent in Q2:2024 and the US population had grown 0.5 percent at the end of 2023. Neutral monetary policy thus implies the money supply should be growing 3.50 percent per year. None of the figures are anywhere close to that, suggesting that monetary policy is tight.

Even after the Fed’s recent rate cuts, data on interest rates and the money supply indicate that monetary policy remains restrictive. Expect the Fed to continue easing towards the end of the year. The FOMC next meets November 6-7. They will probably lower the target range by 25 basis points, but another 50 basis point cut isn’t out of the question. The important thing is this: Fed officials need to ensure they don’t inadvertently keep money tight for too long. Tomorrow’s downturn won’t fix yesterday’s inflation. It will just compound the misery. The best path forward is to approach neutral policy as carefully as possible.