The September FOMC meeting concluded with the Fed opting for a quarter-point rate cut. Newly appointed Fed Governor and Trump ally Stephen Miran dissented and voted for a half-point cut. More astoundingly, the dot plot showed an outlier calling for a Fed Funds rate below 3% in 2025, which requires 1.25% in rate cuts over the next two meetings. While the dots are anonymous, the mostly likely source is Stephan Miran.
Fed Chair Powell described monetary policy in a recent speech as “no risk free path” because of the upside risks to inflation and downside risks to employment. How can Miran justify his off-the-charts level of dovishness against this economic backdrop?
The r* Debate
Fed Governor Miran made a speech at the Economic Club of New York, entitled “Nonmonetary Forces and Appropriate Monetary Policy”, to support his views. To his credit, he offered a high level of transparency to justify his views.
Miran acknowledged that under standard Taylor Rule assumptions, the Fed Funds rate should be 3.6–3.9%, which is not far from the current rate and leaves monetary policy moderately restrictive.
Miran went on to describe the three factors underpinning the Taylor Rule as “inflation, the neutral rate of interest, and the output gap”. While Fed officials focus mainly on inflation and employment, which is one way of measuring the output gap, he called changes in the neutral rate, or r*, as “often unappreciated”.
He argued that “previously high immigration rates and large fiscally driven decreases in net national saving, both of which raise neutral rates, were insufficiently accounted for in previous estimates of neutral rates”. Instead, r* should be lower, and much lower because of Trump’s policies of “shifts in border and tax policy, trade renegotiation and regulatory dynamics”.
Starting with rents and its effect on inflation statistics. Rental inflation has fallen faster than owners’ equivalent rent, which is a key component to CPI. Moreover, lower net immigration should put downward pressure on rental rates.
In addition, Trump’s restrictive immigration policy has lowered population growth. Combined with a naturally aging population “which increases the supply of capital and reduces demand for investment”, Miran cited a study that “a 1 percentage point drop in annual population growth can reduce r* by 0.6 percentage point”.
As for trade policy, Miran pointed out that the Congressional Budget Office projects tariff revenues to raise federal budget revenues by $380 billion a year for the next 10 years, which improves the demand-supply for loanable funds. Further, “loans and loan guarantees pledged by East Asian countries in exchange for relatively low tariff ceilings have reached $900 billion”, which further increases loanable fund supply and puts downward pressure on r*.
Turning to tax policy, the OBBB Act is expected to have a net positive impact on the savings rate. Higher savings translates into increased capital supply and a downward pressure on r*: “The CEA calculates an increase in national saving of $3.83 trillion over the next 10 years (relative to the previous policy baseline), resulting from economic growth induced by tax policy. This represents roughly 1.3 percent of GDP, implying a half of a percentage point reduction in r*”.
However, Trump’s deregulation efforts raises r*. Miran argues that deregulation increases the cost of capital, and estimates a 0.1–0.2% boost to r*.
Putting it all together, Miran concluded, “Including the shocks I’ve considered, I get a new real r* that is 1 to 1.2 percentage points lower, or near zero.”
Wow!
Assume a Can Opener
Miran’s speech should be complimented for its transparency, but it was an adroit exercise in political gymnastics in advancing the Trump agenda of lower interest rates. Former Fed economist Claudia Sahm contrasted Miran’s approach as theoretical and model-based, compared to the more conventional data-based approach to monetary policy used by Jerome Powell and other Fed officials:
His justification for 150 basis points in cuts within three months rested on his assumptions about how the trade, tax, regulatory, and immigration policies of the Trump administration are affecting the neutral rate of interest, the output gap, and future inflation. It’s a useful conceptual exercise, but how can monetary policy be “very restrictive” and necessitate a series of large rate cuts when actual inflation is moving up and the unemployment rate remains low historically? Miran’s theoretical approach to the neutral rate is the opposite of Powell’s ‘we will know it by its works’ approach.
By contrast, Sahm highlighted the data-based approach outlined by Powell when he said that “there are no risk-free paths”. In particular, inflation remains stubbornly high. While goods based CPI has been affected by rising tariffs, services CPI, which is not directly impacted by tariffs, has stabilized above 4%, which is well above the Fed’s 2% target.
Contrast that to Miran’s dogmatic view based on assumptions on the effects of policy. The Fed’s conventional approach is more flexible and responds to changes in the data. Monetary policy according to Miran’s doctrine will be inflexible and risks driving the economy over a cliff.
The main support for Miran’s views is his choice of models and assumptions. That brings up the old joke about the economist, physicist and chemist stranded on a desert island with canned food after a shipwreck. The physicist and chemist devise elaborate schemes based on the knowledge of their disciplines to open the cans. The economist says, “Assume a can opener”.
Half-Truth Assumptions
In addition, I have quibbles about some of Miran’s politically motivated assumptions of the effects of different policies on the economy.
Take the effects of Trump’s anti-immigration policies that lowered population growth. Miran cited a study that “a 1 percentage point drop in annual population growth can reduce r* by 0.6 percentage point”. While that is technically correct, I pointed out in the past that the Japanese experience showed falling population had a negative effect on total factor productivity (see
Will America Grow Old Before It Becomes Great Again?). In effect, Miran is saying that the Fed needs to cut rates because immigration policy is tanking the economy.
Miran highlighted the gains of tariff revenues to the federal budget of a projected $380 billion a year, which, all else being equal, would increase the supply of loanable funds and put downward pressure to r*. But he didn’t mention the costs to achieving those gains.
The OBBB Act extended the TCJA tax cuts and, along with other tax provisions, ballooned the fiscal deficit. An increase in the federal deficit will have net negative effects on the supply of loanable funds, which pushes up r*.
As well, the purported $900 billion in “loans and loan guarantees pledged by East Asian countries in exchange for relatively low tariff ceilings” is mostly a smoke-and-mirrors exercise. Japan’s understanding of the agreement amounts to mostly loan guarantees and not fresh capital. CNBC reported that South Korea pointed out its commitment of capital investment would heavily strain its foreign exchange reserves. In the absence of the extension of a Fed swap line, the Koreans would struggle to meet their commitment. But the extension of a Fed swap line means that the Fed would be the funder of last resort of Korean investment into the U.S. Moreover, it’s unclear how Korean appetite for direct investment may have changed in the wake of the recent ICE raid that netted Korean workers in Georgia.
In short, some of Miran’s assumptions represent political cheerleading for White House policies. In some cases, he outlines the benefits without acknowledging the costs. Such an approach undermines the political independence of the Fed.
In conclusion, the culture of the Federal Reserve has been to make decisions based on data. While it hasn’t always been right, and neither has its underlying models, its operating philosophy has been to adjust its doctrine the best way it can. Most recently, the judgment that inflation was transitory in the wake of the pandemic was a mistake and its Flexible Average Inflation Targeting policy is well past its best before date.
By contrast, Miran’s appointment as Fed Governor represents a skillful attempt by the Trump Administration to influence Fed policy. He speaks the language of economists, such as output gap and r*. But his first speech betrays his propensity to pivot from a data-based approach to monetary policy to a politically based less flexible and doctrinal view. Consider how Miran would react to a much stronger-than-expected September Payroll Report. Data-based Fed officials might take that as a signal to adopt a wait-and-see attitude to cutting rates at the next FOMC meeting, but would Miran? The closely watched ADP report came in much softer than expected, but ISM employment ticked up.
Would Miran adopt the dogmatic and doctrinal view of the Church when Galileo proclaimed that the Earth revolves around the Sun instead of the other way around? If President Trump gets his way and takes over the Fed, the market can look forward to a dogmatic and doctrinally driven Federal Reserve.
