The Federal Open Market Committee (FOMC) is set to convene this week to consider adjustments to the federal funds rate (FFR), the primary tool used to influence broad economic conditions. Although recent weak employment figures have led financial markets and media outlets to anticipate a 25 basis point reduction, last week’s inflation data revealed price increases significantly above the Federal Reserve’s 2 percent goal. This combination of rising prices and job market softness hints at a supply-side disruption, creating a complex environment where traditional monetary guidance becomes less clear. In such cases, established policy frameworks often recommend maintaining or even slightly raising interest rates rather than cutting them.
This piece does not aim to endorse a specific decision on interest rates. A small adjustment to the FFR is unlikely to have a major impact on overall economic performance. As previous research indicates, broader market dynamics tend to outweigh the influence of central bank actions, and the Fed’s ability to directly control long-term rates or outcomes like inflation is limited. For example, mortgage borrowing costs declined recently—before any official meeting—reflecting market forces beyond the Fed’s immediate reach. Additionally, the central bank cannot be expected to offset damage caused by poor policy choices, such as tariffs that simultaneously drive up prices and joblessness, complicating its decision-making.
Instead, the focus here is on the weaknesses in the current monetary framework. One major issue is the absence of an objective benchmark for determining the appropriate level of the FFR. Evidence suggests that rule-based approaches provide more reliable guidance and represent the most effective approach within a system that includes a central bank. (Alternative systems without a central bank could rely on market-driven currency mechanisms.)
A widely studied example is the Taylor rule, which links the policy rate to inflation and unemployment—key variables tied to the Fed’s dual mandate. Using the latest figures—3.5 percent annualized CPI inflation over three months, a 4.3 percent unemployment rate in August, and a natural rate of unemployment (NAIRU) estimated at 4.32 percent—the rule calculates a recommended FFR of approximately 4.52 percent. With the current target range at 4.25 to 4.5 percent, the rule implies either stability or a modest upward adjustment. This stands in contrast to the rate cut widely anticipated by investors and analysts.
Another structural flaw lies in how the Fed manages expectations. To prevent market shocks, the central bank uses forward guidance—public signals about future policy. However, when new data emerges that contradicts earlier messaging, the Fed faces a dilemma: stick with outdated guidance to avoid surprises, or update its stance and risk unsettling markets. Currently, earlier signals pointed to a rate reduction due to labor market weakness, but newer inflation data supports holding steady or tightening. This mismatch forces a choice between economic accuracy and credibility preservation.
Adopting a transparent, rule-based system would resolve this. Rules convert economic data directly into policy targets through clear formulas, allowing all participants—from households to financial institutions—to anticipate policy moves in real time. Economic fluctuations would then reflect underlying conditions rather than surprises from policy meetings. While no system is flawless and monetary policy cannot counteract structural issues or poor fiscal decisions, the most effective path forward is for the Fed to commit to rules-based decision-making. If voluntary adoption doesn’t occur, Congress should require adherence to a formal rule, with public explanations required for any departures.
— news from Cato Institute
— News Original —
Economic Data Does Not Support a Fed Rate Cut
The Federal Open Market Committee (FOMC) will meet this week to deliberate on changing the target for the federal funds rate (FFR), the main policy rate used to affect economy-wide changes. After a series of poor employment reports, betting markets and business media expect a rate cut, with a 25 basis point decrease the most likely outcome. However, last week’s inflation report shows that prices are increasing much faster than the Fed’s 2 percent target, indicating real concerns of a supply shock that has caused both inflated prices and unemployment. In such situations, guidance for monetary policy is ambiguous, with a standard monetary policy rule advocating no change to rates or even a slight increase.
To be clear, the point of this article is not to advocate any specific rate decision. In isolation, a minor change to the FFR will neither meaningfully help nor hurt the economy. As our prior work has shown, monetary policy is not as important as other market forces, and the Fed does not really control interest rates, let alone macroeconomic outcomes like inflation. In fact, mortgage rates fell last week, well before the upcoming FOMC meeting. Nor should people expect the Fed to save the economy from the negative effects of bad economic policy, especially supply shocks like tariffs that raise both inflation and unemployment, giving the Fed contrasting signals.
Rather, the point of this article is to highlight how our current predicament exposes flaws in the monetary policy framework. The primary such flaw is the lack of any objective standard to gauge what the “optimal” value of the FFR is. Ample research has shown that monetary policy rules offer the best policy prescriptions and are likely the best-case scenario for a world with a central bank. (Of course, there are several private market-based currency provision alternatives in a world without a central bank.)
The best guess, then, for the optimal value of the FFR is the value computed by using such rules. While there are numerous rules the Fed could follow, one example is the Taylor rule: an equation that relates the Fed’s policy rate target to its dual mandate macro indicators (inflation and unemployment). Using the most recently available data, the Taylor rule suggests the Fed’s current target is roughly correct. The following equation is a simplified Taylor rule:
FFRt = 0.8 x FFRt‑1 + ( 1 — 0.8 ) x [ 1.5 x Inflationt — 0.5 x ( Unemployment Ratet — NAIRUt ) ]
The current value of the FFR is 4.33%, and the latest annualized 3‑month CPI inflation was 3.5%. Using August’s unemployment rate of 4.3% and a 4.32% natural rate (NAIRU), the implied current FFR should be:
FFRSept 2025 = 0.8 x (4.33%) + 0.2 x [ 1.5 x (3.5%) — 0.5 x (4.3% — 4.32%) ] = 4.52%
Given that the FOMC’s current target range for the FFR is 4.25 to 4.5%, a standard rule advises no change or maybe even a 25 basis point increase to this target. It certainly does not advocate the rate cut that markets and analysts expect. But the way the Fed sets these expectations is another major flaw and could also be fixed by following a rule.
Understandably, the Fed does not want to become a source of macroeconomic fluctuations itself. This can happen if the Fed surprises markets by setting the target rate in a manner that is different from private sector expectations. To avoid this, the Fed routinely engages in forward guidance, using public statements and reports to indicate its course of action well in advance of FOMC meetings. The drawback to this approach is that new data could alter the Fed’s view on the economy. The Fed would then be forced to choose between making an incorrect rate decision to prevent surprising markets or altering its previously indicated stance by correctly setting the rate but surprising markets.
This scenario describes our current situation. As shown above, the latest inflation data support holding rates steady at best and may even support an increase. But the Fed’s statements, primarily in response to weakening labor market data, have all indicated a rate cut. The Fed must now choose between following the correct economic policy or risk surprising markets (and its credibility) by reversing its indicated course of action.
This problem could also be fixed if the Fed set the target rate by following a rule. Since rules offer a direct arithmetic calculation that turns macro data into an interest rate target, they are the most effective form of forward guidance. All market participants, from consumers to Wall Street, would react to data in real time and know with certainty what the Fed’s policy rate target will be. As a result, macroeconomic fluctuations would be driven by the underlying economy rather than by FOMC meetings.
No one should expect monetary policy to be perfect. It cannot overcome natural business cycles or bad policies. The best version of monetary policy under our current system is for the Fed to commit to rules-based policymaking going forward. Absent such reforms, Congress must act to secure policy consistency by mandating that the Fed adhere to a rule and provide public justification for any deviations.