Heavyweight Pre-Meeting Announcement! "Fed's Signal Transmitter": Rate Cut Finally Enters the Picture

"The Federal Reserve Megaphone" Nick Timiraos' latest article states that Federal Reserve officials are unlikely to change interest rates this week, however, this week's meeting will still be one of the most important meetings in a while.

At the four meetings so far this year, each rate cut has been seen as "a problem for later". However, this time, developments in inflation and the labor market are expected to signal a rate cut at the September meeting. Therefore, this week's meeting may end the balancing act Federal Reserve Chairman Powell has been doing between cutting rates too early and waiting too long, with Powell leaning towards taking action sooner.

Although the likelihood of a rate cut is increasing, one reason officials are unlikely to cut rates this time is that it may be the first rate cut in a series of rate adjustments. Officials have been consistently surprised by inflation and they want more evidence of cooling inflation before crossing the rate cut threshold.

Nevertheless, officials are increasingly concerned that waiting too long could lead to a failed soft landing. Powell told lawmakers this month that bringing the inflation rate down to the Fed's 2% target while maintaining a healthy labor market is "the top priority that keeps me up at night".

In a recent interview, New York Fed President Williams hinted that there was no need to cut rates in July, saying officials will "learn a lot between July and September" and noting recent robust economic activity. But he added, "We will make a decision at some point" on how to "reduce rates in a way that loosens policy constraints".

The recent Fed readiness to cut rates reflects three factors: positive news on inflation, signs of cooling in the job market, and a changing consideration of the dual risks of allowing inflation to remain too high and causing unnecessary economic weakness.

Resumption of Inflation Decline

A potential inflation indicator excluding food and energy prices fell to 2.6% in June, lower than the peak of 4.3% a year ago and 5.6% two years ago.

Williams said this decline is widespread, dismissing concerns that getting rates back to the Fed's 2% target would be exceptionally difficult. Williams said, "This is not a story about the 'last mile' or some particularly tricky part. Different inflation indicators are moving in the right direction and are quite consistent."

Due to the easing of labor and product market bottlenecks, despite steady economic growth, inflation rates fell last year. Powell has repeatedly warned that waiting for the inflation rate to reach 2% before cutting rates means "you may have waited too long".

Cooling Labor Market

In June this year, the U.S. unemployment rate rose from 3.7% at the end of last year to 4.1%, mainly due to a slowdown in hiring, with new employees or those re-entering the labor market taking longer to find jobs. This limits workers' ability to seek significantly higher pay increases that could sustain higher inflation Recently, Jerome Powell observed that the labor market "is not a source of broad inflationary pressure," indicating that the main source of anxiety about the possibility of inflation has diminished.

Two years ago, Federal Reserve officials believed that the labor market was so imbalanced that companies might respond to rising interest rates and weak demand by cutting job vacancies rather than laying off workers. So far, that's what has happened.

Fed Governor Lael Brainard stated in a recent speech: "Right now, the labor market is in the best position." Brainard is one of the most optimistic advocates of this argument. He said, "We need to keep the labor market in this best position." Similar analysis also predicts that the cooling of the labor market will only last for a period of time, and at some point, the traditional balance between reduced labor demand and rising unemployment rates will return.

Former Fed Vice Chairman Clarida said: "If you've really gone this far along a path that is considered very, very bold and deviates from consensus, then yes, you want to stick the landing."

Shift in Risk Management

With inflation resurfacing and the labor market cooling down, Fed officials are facing a shift in balance, which they often refer to as risk management, boiled down to which problem they believe is harder to solve - rising inflation or rising unemployment.

Two years ago, the Fed hesitated to raise interest rates, in part because it incorrectly judged that inflation would quickly fade. The Fed was able to correct this mistake, but to do so, it would have to quickly raise rates from near zero in 2022 to around 5.3% in July 2023, the highest level in over 20 years. One lesson is: "When you are too confident that your views are correct, you are prone to making mistakes," said Mary Daly, President of the Federal Reserve Bank of San Francisco.

The Fed expects that demand or hiring will not weaken significantly in the coming months, but if the forecast is wrong, it may not be able to lower rates quickly enough to prevent an economic downturn. Daly said, "If you haven't (lowered rates) when the labor market starts to soften, then it's really challenging to get it back on track. This is different from starting to raise rates two years too late."

Some officials have already rehearsed arguments they might use to persuade colleagues that it is time to lower rates. "We set this rate when inflation exceeded 4%, and now the inflation rate is 2.5%. This means we have significantly tightened monetary policy since maintaining the current rate level," said Charles Evans, President of the Federal Reserve Bank of Chicago, in an interview. "You just want to keep this restriction in place when necessary, and to me, it doesn't seem like the economy is overheating right now."

However, more policymakers, including Daly, have indicated that they believe they can wait a little longer, highlighting their delicate balancing act. Daly stated at a meeting earlier this month that even with recent improvements in inflation data, "we have not yet achieved price stability." She said history warns us not to "take preemptive or emergency action when it is not needed."