Policy tightness threatens soft landing
Tight policy, rising delinquencies, and a soft Q1 GDP print suggest the Fed should act preemptively to maintain stability and avoid deeper fallout.
There has been a strong link between the US dollar and real interest rates—higher real rates tend to attract global capital, offering investors returns above inflation. However, despite elevated real rates, the dollar hasn’t displayed its typical “safe haven” behavior during recent market volatility. Looking ahead, if the Federal Reserve begins cutting policy rates, this could create additional headwinds for the dollar.
Weekly Highlights
Policy rate minus current CPI as of June 30, 2025
Policy rate minus current CPI as of June 30, 2025
Policy rate minus current CPI as of June 30, 2025
The Path to Neutral: A Strategic Case for Fed Easing in 2025
The US economy has shown resilience despite historically tight monetary policy. Equity markets remain firm, labor markets are tight, and consumer demand has held up. However, this strength should not be mistaken for permanence. Beneath the surface, structural distortions and early-stage financial stress are emerging. Economic conditions continue to align with our view that the Federal Reserve should deliver three rate cuts in 2025—Not to stimulate, but to normalize policy and preserve momentum.
The accompanying chart compares the Fed’s policy rate with 5 year forward real rates. Compared to its history, the elevated 5 year real rates seen over the past 3 years highlight the degree of real monetary tightness the economy has endured.
Despite cooling inflation expectations, the Fed’s stance remains aggressively tight in real terms, and well above most estimates of the neutral rate. This divergence has quietly tightened financial conditions, having implications on credit transmission, capital formation, and broader financial stability.
Observing the chart, it’s clear that both the 2008 Great Financial Crisis as well as the Covid-19 market crash were preceded by a high fed funds rate, and meaningfully positive real yields. While it would be an overstatement to say that elevated Fed policy rates and real yields directly caused the 2008 or 2020 financial crises, they undoubtedly materially reduced the economy’s margin for error. In such tight policy environments, events such as a bank failures, policy missteps, as well as exogenous events can trigger disproportionate fallout. While monetary tightening rarely ignites the fire, it can certainly supply the oxygen.
Credit card delinquencies are at their highest level since Q4 2011, when unemployment stood at 9%. While today’s labor market remains stronger, jobless claims are rising, and housing activity is softening. These are legitimate warning signs. If left unaddressed, they risk compounding into broader dislocations that would require more aggressive intervention later.
At the same time, it is important to acknowledge that the sky is not falling. The Q1 2025 GDP contraction, while headline negative, was largely driven by a surge in imports following tariff adjustments. Since imports are subtracted in GDP accounting, the figure understates the strength of domestic demand. Similarly, the S&P 500’s recovery from its Q1 drawdown—now positive year-to-date—reflects underlying resilience. Although these two major economic indicators are stable at this point in time, they do not eliminate the need for forward-looking policy action.
As we approach the Fed’s Jackson Hole policy symposium in late August, we believe the policy narrative must evolve, that is of course barring any major surprises to incoming unemployment/inflation data in the coming month. Cutting the policy rate sooner rather than later would not be dovish, but prudent, as we are simply returning to near neutral. Easing now would help preserve the soft landing that remains our base case and reduces the risk of needing more forceful and potentially costly action later.
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