The Divided Rate Cut Reveals the Federal Reserve’s Structural Weakness

 

The Divided Rate Cut Reveals the Federal Reserve’s Structural Weakness

 

This morning’s Nikkei editorial, “A Divided Rate Cut Tests the Fed’s Credibility,” offers a persuasive account of the unusual dissent within the FOMC and the growing political pressure surrounding U.S. monetary policy. Yet the editorial stops short of addressing a deeper, long‑standing structural flaw—an Achilles’ heel that has quietly shaped the Federal Reserve’s policy framework for years.

 

That flaw is the Fed’s persistent and arbitrary assumption that the nominal neutral interest rate is roughly 3 percent. This assumption, rarely questioned in public debate, has profound implications for how the Fed interprets inflation, growth, and the stance of monetary policy.

The Fed’s Own Forecasts Imply a Nominal Growth Rate of Only 3.9%

In its Summary of Economic Projections (SEP), the FOMC presents the following long‑run assumptions:

• Inflation target: 2%
• Real GDP growth: 1.9%

Taken together, these imply a long‑run nominal GDP growth rate of only 3.9%.

But this is far below historical experience.
Since 1980, U.S. nominal GDP has grown at an average annual rate of 5.8%.
The Fed’s long‑run assumptions therefore paint a picture of an economy far weaker than its historical performance would suggest.

A 3% Neutral Rate Implies Real Growth of Only 1%

If the Fed insists that the nominal neutral rate is just 3%, and if inflation is anchored at 2%, then the Fed is implicitly assuming:

Long‑run real GDP growth = 1%

This is inconsistent with both the SEP’s own 1.9% real growth estimate and the historical dynamism of the U.S. economy.
The internal inconsistency is striking: the Fed cannot simultaneously assume 1.9% real growth and a 3% nominal neutral rate without contradicting itself.

A More Coherent Neutral Rate Is Around 4%

If the Fed’s long‑run nominal growth assumption is 3.9%, then the neutral rate should logically be:

• 3.9%, or
• “about 4%”, a level far easier for the public to understand.

The current 3% estimate is not only arbitrary but also analytically inconsistent with the Fed’s own projections.

The Latest Rate Cut Has Already Pushed Policy Below Neutral

With the latest 25‑basis‑point cut, the federal funds rate now stands at 3.75%.
Although this still implies a positive real policy rate consistent with the Taylor principle, it is below the true neutral rate implied by long‑run nominal growth.

In other words, the Fed has already slipped into a mildly stimulative stance, even as inflation risks remain unresolved.

If the Fed continues to cling to an artificially low 3% neutral rate, markets will naturally expect further cuts in 2026 and 2027.
Such expectations risk fueling:

• renewed inflation pressures
• asset price overheating
• and a broader erosion of policy credibility  

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The Rate‑Cut Cycle Actually Began in August 2024

Contrary to the common narrative, the easing cycle did not begin in 2025.
It began in August 2024, when Chair Powell signaled a “preliminary rate cut” at the Jackson Hole symposium.

Since then, the policy rate has been lowered by a cumulative 125 basis points.
Yet the 10‑year Treasury yield has risen, not fallen.

This divergence suggests that markets are increasingly concerned about future inflation, and that the Fed’s credibility may already be weakening.

The Nikkei Editorial Captures the Symptoms, but Not the Cause

The Nikkei editorial rightly highlights:

• internal divisions within the FOMC
• uncertainty caused by delayed economic data
• intensifying political pressure on the Fed

These are important issues.
But they are symptoms, not the underlying cause.

The deeper problem is the Fed’s structurally flawed estimate of the neutral rate, which distorts policy decisions and undermines credibility.

 

Conclusion: Credibility Is Eroding Not Because the Vote Was Divided, but Because the Framework Is Flawed

The real threat to the Fed’s credibility is not the split vote itself.
It is the fact that the Fed continues to base its decisions on a nominal neutral rate that is too low, internally inconsistent, and historically implausible.

Unless the Fed revises this foundational assumption, inflation expectations and asset valuations will remain vulnerable to renewed instability.