Former Fed Vice Chairman Dudley changes his tune, supports rate cut in July: Fed needs to act now

Former "Fed's No. 3" William Dudley, who served as the President of the New York Fed from 2009 to 2018, has changed his stance from advocating for high interest rates to calling for a rate cut this month.

In a column published on Wednesday, July 24th, Dudley titled "I've changed my mind, the Fed needs to cut rates now," stating that the Fed doesn't need to wait until September to cut rates as it would increase the risk of an economic recession.

Dudley began his article by mentioning that for a long time, he belonged to the camp that advocated for "keeping high rates longer," insisting that in order for the Fed to control inflation, short-term rates must be kept at or above current levels. He then wrote:

"The reality has changed, so I changed my mind too. The Fed should cut rates, preferably at next week's policy meeting."

Dudley believes that the Fed's efforts to cool the U.S. economy have been effective: wealthy households are still spending, while other groups are feeling the impact of rising rates as they deplete the savings from previous government fiscal stimulus. Rising loan costs are causing a downturn in housing construction; government investment plans seem to be losing momentum; job growth is slowing, and most concerning, the three-month average unemployment rate has risen by 0.43 percentage points from its low point in the previous 12 months, very close to the 0.5 threshold set by the Sam rule, which indicates an economic recession if exceeded.

At the same time, inflation pressures have significantly weakened. The Fed's preferred inflation gauge, the core PCE price index, grew by 2.6% year-on-year, slightly above the Fed's inflation target of 2%. Based on the published data used to calculate the core PCE, the June PCE index may reinforce the trend of slowing inflation.

In this scenario, why are Fed officials hinting that there won't be a rate cut at the monetary policy meeting at the end of this month? Dudley believes there are three reasons.

First, the Fed is reluctant to be fooled again. Data at the end of last year showed a slowdown in inflation, but it proved to be short-lived as inflation picked up again in the first three months of this year. Given the low base in the second half of last year, it will be difficult to slow down year-on-year inflation in the future. Therefore, Fed officials may be unwilling to declare success in lowering inflation.

Second, Fed Chair Powell may be waiting for a broad consensus within the Fed to cut rates as universally as possible. Since the market has already fully anticipated a rate cut in September, Powell can argue to the doves that delaying the rate cut won't have a significant impact, while also garnering more support from the hawks.

Third, Fed officials may have misunderstood the labor market and are not very concerned about the risk of the unemployment rate surpassing the Sam rule threshold, as they believe that the rise in unemployment is due to rapid labor force growth rather than increased layoffs. Dudley points out that this logic is not convincing, as the Sam rule accurately predicted the economic recession in the 1970s when the U.S. labor force was also growing rapidly.

Dudley notes that historical records show that a deterioration in the labor market can create a self-reinforcing feedback loop. As jobs become harder to find, households cut back on spending, the economy weakens, businesses reduce investment, leading to layoffs and further spending cuts. This can explain why the unemployment rate always significantly rises after surpassing the 0.5% threshold of the Sam rule In other words, Dudley is warning that historical experience shows that when the labor market cools down as it is now, it tends to show a faster downward trend.

At the end of the article, Dudley calls for:

Although it may be too late to resist an economic downturn by cutting interest rates, delaying action now will only unnecessarily increase risks.

Currently, most economists expect the Federal Reserve to continue to keep interest rates unchanged next week. However, Wall Street News notes that some economists, like Dudley, advocate for a rate cut now. For example, Jan Hatzius, Chief Economist at Goldman Sachs, stated in a research report released earlier this month that the reasons for the Fed to cut rates at the end of July were sufficient. First, if the reasons for cutting rates are clear, why wait another seven weeks to act? Second, data released before the meetings from July to September may not align with the Fed's needs, making a rate cut in September awkward. In addition, taking action in July can avoid the Fed's first rate cut in the last two months of the presidential election season