Reading mixed signals in a fragile economy

Federal Reserve cut interest rates last week, but the decision was far from unanimous. Two members of the Federal Open Market Committee dissented, an unusual occurrence that reveals deep disagreement about where the economy is heading.

Even more striking: the dissenters pulled in opposite directions. One wanted no rate cut at all, believing the Fed should hold steady.

The other favored a more aggressive half-percentage-point reduction. This split would be challenging enough under normal circumstances, but the Fed faces an extraordinary handicap: it's flying blind.

Official economic data hasn't been updated in more than a month, forcing policymakers to make consequential decisions based on incomplete information, anecdotal evidence and private-sector estimates. The challenge isn't just that the economy is sending contradictory signals – it's that many of the most important signals aren't being sent at all.

Competing diagnoses

The dovish perspective, articulated by the newest Fed Governor Stephen Miran, rests on a critical technical point: the "neutral rate" of interest may be lower than previously thought.

The neutral rate is the level at which monetary policy neither stimulates nor restricts economic activity, essentially the speed limit for the economy. Miran argues that recent policy changes – tariffs, immigration – are likely to reduce America's long-term economic potential, which in turn means the neutral rate has declined. If he's right, keeping interest rates at current levels amounts to slamming the brakes far harder than intended.

The evidence for this view is visible in two critical sectors. The labor market has cooled considerably, with hiring slowing to barely a trickle.

Meanwhile, the housing market remains frozen, with potential buyers locked out by elevated mortgage rates. These aren't signs of a healthy economy being gently guided toward stable prices. They suggest an economy being actively choked.

Kansas City Fed President Jeff Schmid sees things differently. In his view, monetary policy is only "modestly restrictive" at best. His evidence? Look at financial markets, he argues. Stock markets hover near record highs. Companies can borrow cheaply.

To understand why this matters, consider that when corporations issue bonds, they must pay higher interest rates than the U.S. government does on Treasury bonds. Investors demand this premium to compensate for the added risk of lending to a company rather than to Uncle Sam.

This difference is called the "spread." Right now, these spreads are extremely narrow, meaning corporations are paying only slightly more than the government to borrow.

Narrow spreads signal that investors feel confident about corporate creditworthiness and are willing to accept minimal compensation for risk. In Schmid's view, this indicates easy financial conditions. If monetary policy truly were restrictive, nervous investors would demand much higher premiums to lend to corporations, widening these spreads considerably.

Moreover, Schmid points to robust economic activity. Consumer spending remains solid and actually accelerated through the summer. Most telling, he notes, is that business investment in equipment and software has been booming.

Software spending's contribution to GDP growth hit a record in the second quarter. Information technology investment in the first quarter reached its highest level since the dot-com bubble of 2000.

With inflation still elevated, Schmid concludes, the Fed should keep demand steady to give supply chains and businesses time to expand capacity and ease price pressures.

Warning signs for labor market

But here's where Schmid's optimistic reading runs into trouble: the labor market data tells a darker story. Employment growth has essentially stalled. Hiring rates remain depressed across the economy. Only half of U.S. industries are still adding workers and definitely not committing to any major expansion plans.

The government shutdown compounds these headwinds, leaving thousands of federal workers without paychecks. These workers will inevitably cut back on spending, creating ripple effects throughout the economy.

The frozen labor market means most workers won't see meaningful raises in 2025, effectively eliminating the risk of a wage-price spiral that has worried inflation hawks. When workers' paychecks don't keep pace with inflation, they reduce spending. And since consumer spending comprises roughly 70% of U.S. economic activity, even modest pullbacks create significant drag.