The federal funds rate set by the Federal Reserve currently sits at 4.75% to 5.00% after policymakers reduced it by 50 basis points in September.

Last week during a public appearance at Stanford University, Fed governor Christopher Waller said he and many of his fellow members of the Federal Open Market Committee (FOMC) anticipate rates falling to about 3.4% by the end of next year.

“There is less certainty about the final destination,” Waller acknowledged to attendees at a conference sponsored by the Hoover Institution at Stanford. “The median estimated longer-run level of the federal funds rate in the Committee’s Summary of Economic Projections (SEP) is 2.9 percent, but with quite a wide dispersion, ranging from 2.4 percent to 3.8 percent.

“While much attention is given to the size of cuts over the next meeting or two, I think the larger message of the SEP is that there is a considerable extent of policy restrictiveness to remove, and if the economy continues in its current sweet spot, this will happen gradually,” Waller continued.

Earlier in his prepared remarks, Waller further explained why changes make the Fed gradually filter through the economy into places such as auto financing.

Waller based his analysis on The Taylor Rule and the Transformation of Monetary Policy, written by George Kahn and published in 2012. According to Waller, the book contained two major segments that often sway how the Fed approaches policymaking.

Waller said the methodology changed in the 1990s, “as the Fed was moving away from monetary targeting, focusing more on interest-rate policy, and taking its first major steps toward increased transparency.”

The first part is an inertial rule, which Waller said, “has the property that the policy rate changes only slowly over time. I tend to think of it as an approach that captures the reaction function of a policymaker in a stable economy where the forces that would tend to change the economy and policy build over time.

“When change does occur, a gradual response may give policymakers time to assess the true state of the economy and the possible effects of their decision. One example I can use is the steadfastness of policymakers in the latter part of 2023, when inflation fell more rapidly than was widely expected, and again in early 2024, when it briefly escalated. The FOMC did not change course either time, an approach validated by inertial rules,” he continued.

Then Waller touched on a non-inertial rule, which he said, “allows and in fact calls for relatively quick adjustments to policy. The guidance from these rules is more useful when there is a turning point in the economy, and policymakers need to stay ahead of events.

“One saw these non-inertial rules prescribe a sharper rise in the policy rate above the effective lower bound starting in 2021 as inflation began climbing above the FOMC’s 2 percent target. Non-inertial rules are also more useful in the face of major shocks to the economy such as the 2008 financial crisis and the start of the pandemic,” Waller continued.

Waller went on to say that these principles likely will influence what the Fed does next. Policymakers will announce their next decision soon after Election Day in November.

“The great promise of rules is that they provide a simple and reliable guide to policy, but what should one do when different rules recommend different policy actions given the same economic conditions? Right now, inertial rules tell us to move slowly in reducing policy rates toward a neutral stance that neither restricts nor stimulates the economy. On the other hand, non-inertial rules tell us to cut the policy rate more aggressively, subject to the caveat that one is certain of the values of all the ‘star’ variables,” Waller said.

“I think the answer is that while rules are valuable in helping analyze policy options, they have limitations,” he went on to say. “Among these are the limits of the data considered, which is typically narrower than the range of data that policymakers use to make decisions, and also the fact that simple policy rules do not take into account risk management, which is often a critical consideration in policy decisions. So, while policy rules serve as a good check on discretionary policy, there are times when discretion is needed. As a result, I prefer to think of them as ‘policy rules of thumb.’”