The Federal Open Market Committee is expected to leave its policy rate unchanged at this week’s meeting, with CME FedWatch assigning close to a 65 percent probability that the FOMC will maintain the current target range of 3.5 to 3.75 percent. For the second meeting in a row, that expected outcome is at odds with the guidance provided by the leading monetary rules. This raises the question of whether the new Warsh-led Fed is prepared to follow through on its promise of delivering price stability.
What the Rules Say
The latest Monetary Rules Report from AIER’s Sound Money Project shows that the Fed’s current policy rate falls below the range recommended by leading monetary rules. All twelve estimates in the report indicate that the Fed should raise its policy rate at the upcoming meeting.
The strongest case for tighter policy comes from Taylor-type rules. These rules respond to both inflation and labor market conditions, raising the recommended policy rate when inflation exceeds the Fed’s target unless that pressure is offset by significant economic weakness. With inflation still well above 2 percent and little evidence of substantial labor market weakness, both factors point toward a less accommodative policy stance.
The original Taylor Rule produces the most aggressive estimate, prescribing a federal funds rate of 6.01 percent. A modified version, which places more weight on the current policy rate and uses a forecast of future inflation, produces a lower estimate of 4.24 percent. Even after incorporating those more gradual and forward-looking features, however, the rule still prescribes a federal funds rate roughly half a percentage point above the current target range.
Rules based on nominal GDP, or total dollar spending in the economy, tell a similar story. A nominal GDP growth rule, which calls for raising rates when nominal GDP growth exceeds 4 percent, points to a 4.25 percent policy rate. A nominal GDP level rule, which recommends raising rates when total spending exceeds a steady growth path, produces the lowest estimate, at 3.76 percent. That prescription is very close to the upper bound of the current target range. Nevertheless, it is also consistent with a 25-basis-point hike, especially when considered alongside the other rules.
A Test of the Fed’s Credibility
The first FOMC statement of the Warsh era plainly stated, “The Committee will deliver price stability.” With inflation still well above the Fed’s 2-percent target and every leading monetary rule pointing toward a rate increase, will Warsh and his colleagues follow through on that promise and tighten monetary policy? The market considers a hike possible but unlikely, with CME FedWatch pricing in roughly a 35 percent probability of a 25-basis-point increase.
The committee can offer several reasons for waiting at least one more meeting before raising rates. The latest inflation data showed a notable decline in June, with the year-over-year CPI inflation rate falling from 4.2 percent in May to 3.5 percent in June, while overall prices declined by 0.4 percent on a monthly basis. Officials may want to see whether that trend continues through the next September FOMC meeting before tightening policy. The Fed will also likely receive some assistance from a planned change in how the BEA calculates the Fed’s preferred inflation gauge, the PCE price index, which may trim a few tenths from the PCE inflation rate this fall. Estimates of second-quarter growth have also weakened. The Atlanta Fed’s GDPNow model currently puts real GDP growth at just 1.7 percent, down from the first quarter’s 2.1 percent pace.
Taken together, these factors make a plausible case for waiting. If inflation falls toward 2.5 percent and real growth slows to roughly 1.5 percent, nominal GDP growth would return to the NGDP growth rule’s 4 percent benchmark by September. Under that scenario, the current policy rate might prove appropriate, and a July increase would look premature.
The problem with this argument is that it assumes too much. The conflict with Iran is re-escalating, and despite energy prices declining from May to June, average gas prices are already pushing back over $4 while diesel prices exceed $5. The Fed should generally avoid overreacting to a temporary supply shock, but it should also be cautious about assuming inflationary pressures will resolve on their own, especially given the uncertain path of the conflict. And while the BEA update may bring the Fed’s preferred inflation rate down slightly, Fed officials should not rely on methodological revisions to deliver price stability. Lastly, even if real GDP growth in the second quarter comes in a bit below 2 percent, NGDP growth would likely still exceed 4 percent without any signs of imminent weakness in the labor market. Overall, if the Warsh Fed is serious about delivering price stability, it’s time to start backing up words with actions.
Words and Actions
Chair Warsh has called for less groupthink and more open disagreement inside the FOMC. Dallas Fed President Lorie Logan may provide an early test of that commitment by making the case for higher rates at the July meeting. With nearly half of FOMC participants projecting at least one increase in 2026, she may find considerable support even if a majority is not yet prepared to act.
If the Fed leaves rates unchanged this week, the September meeting will take on added importance. Another two months of inflation near current levels would make it increasingly difficult for the Committee to reconcile its commitment to deliver price stability with its reluctance to raise rates. The leading monetary rules already indicate that policy is too accommodative. If inflation remains elevated, the Warsh Fed will eventually have to back its promise of price stability with action.
