Economic Monitor – Weekly Commentary
by Eugenio Alemán

Monetary policy: Rules vs. discretion or a happy medium?

August 22, 2025

Chief Economist Eugenio J. Alemán discusses current economic conditions.

We have been outspoken on the need to cut interest rates sooner rather than later to prevent a recession, as we considered rates too restrictive for the slowing rate of growth of the economy at a time when inflation remained very close to the Federal Reserve’s (Fed) target of 2.0%. We still expect two rate cuts before year end, premised on our economic forecast, which has the economy slowing to a trickle and moving close to recessionary levels, which is why we argued for lower rates during the first half of the year.

But inflation is going to start rearing its ugly head very soon, and, as we said over the last several months, the window to lower rates is closing very quickly, if it hasn’t closed yet. At the same time, the fiscally expansionary effects of the One Big Beautiful Bill Act (OBBBA) are front-loaded, so if the economy is able to avoid a recession, the Fed probably will have to deal with stronger growth in 2026, which could prevent it from lowering interest rates as markets are currently expecting. All this complicates the job of Fed members as they conclude their Jackson Hole meeting and as they approach the September Federal Open Market Committee (FOMC) meeting, two meetings where they will face continued pressure from political actors as well as real pressure from higher inflation readings.

At the same time, we understand the Fed typically follows what markets expect on rates, and today, markets are expecting the Fed to lower rates by 25 basis points during the September FOMC meeting. If the market’s assumption for requiring lower interest rates is that the economy is at risk of falling into a recession, the market’s view would be in line with our view and would require the Fed to lower rates as soon as possible, even if markets have the Fed starting with rate cuts in September versus October for us.

Fed officials’ views since December have been that they are holding off on cutting rates further because the economy continues to grow at a relatively strong pace, while adding, early in the year, that they are waiting to have more certainty on the path of tariffs and their potential effects on inflation. For us, the recent weakness in employment should be a wake-up call for the Fed if it is preparing to cut rates. Additionally, on September 9, the Bureau of Labor Statistics (BLS) will issue its preliminary benchmark revisions to Establishment Survey Data, revising nonfarm payrolls between April 2024 and September 2025. These benchmark revisions could indicate that job growth was even weaker than initially reported, suggesting the economy may be on a more fragile footing than previously believed.

However, the fact that the full effect of tariffs on prices, plus the continuous delay on higher tariffs on Chinese imports, is still not fully accounted for in the data creates more issues for the path of interest rates. It will be interesting to hear Chairman Powell today at Jackson Hole on the new monetary policy framework to see if the institution makes substantive revisions to the previous framework, which was created after the Great Recession disinflationary environment.¹ That is, policymakers could make amendments to the policy, potentially changing the way they are going to react to changes in inflation. If they go back to the previous framework, then the discussion on interest rates will probably change substantively.

They could also modify their view on the current economic environment and argue that weakness in employment trumps their current concern about the effects of tariffs on inflation. However, in order to do that, they would have to believe that the deterioration in employment is such that if they don’t move today, they risk sending the US economy into recession.

As we have argued many times in the past, monetary policy is not conducive to a large increase in inflation or if there is higher inflation, the increase will be temporary. This is because real money supply is growing very slowly, as shown in the graph below, while real disposable income has slowed down considerably, making any potential increase in inflation due to tariffs short-lived, which is very different from what happened during the recovery from the COVID-19 pandemic, as shown in the graph on the next page.

1: This framework was adopted in 2012 and revised further in 2024. Here is a link to the Federal Reserve current framework. https://www.federalreserve.gov/monetarypolicy/ files/FOMC_LongerRunGoals.pdf?utm_source=substack&utm_medium=email

Of course, if the Fed reduces interest rates as the Trump administration is proposing or if the administration goes forward with rebating the increase in tax revenues from tariffs back to individuals, this story could change considerably and the potential for inflation that increases and stays higher for longer will increase.

Perhaps the biggest threat we see today has to do with the potential for resetting inflation expectations or what the Fed calls inflationary expectations becoming unanchored. This is what happened during the stagflationary scenarios of the 70s and 80s. However, for that to happen, monetary policy would need to become prey to political pressure, which would mean that the lack of independence in the Fed decision- making process would threaten monetary policy consistency, as occurred during that period.

Although we still don’t see this as a high-risk event, the continued threat to Fed independence is a major risk going forward. If the Fed remains independent from the political process, the Fed will remain cautious when conducting monetary policy. Today, we have a system (with rules like the Taylor rule that wasn’t in place during the 70s and 80s, when changes in monetary policy were more discretionary, with too much political system meddling in monetary policy decisions, which contributed to generating stagflation.²

2: The Taylor Rule is a monetary policy guideline that suggests how central banks should set short-term interest rates in response to changes in inflation and economic output.

Today, they have a mix of rules as well as some discretion to adapt to the current economic environment as well as an inflation targeting mechanism that did not exist back then. Thus, they are much better prepared to avoid a repeat of a stagflation environment. Of course, they have no control over fiscal policy and trade (i.e., tariff policies) so they will have to remain vigilant for the potential effects of those ‘shocks.’

Another risk is a geopolitical shock, like another war that could increase the price of petroleum, as happened during the 70s and 80s. All these events could make a dent in inflation expectations and could make the Fed’s inflation fight even more difficult going forward.

If this was not enough, the current administration’s push to reduce/eliminate the independence of the Federal Reserve, which we wrote about in our Weekly Economics on April 25, 2025 is probably one of the biggest risks to inflation because it will not only make it easier for inflation to increase but it will negatively affect economic agents’ trust in the institution and could make inflationary expectation unanchored. This will have negative consequences for inflation, the US dollar, as well as the standing of the US economy around the globe.

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Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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