The logic behind a 50 basis point rate cut: Beveridge curve returning to normalcy

Key Points

A shift in focus of the Federal Reserve's policy. The rate cut initiated at the September FOMC meeting has become a certainty, with the key being the magnitude of this rate cut—50 basis points. Expectations for a rate cut in September changed in the days leading up to the meeting, but the latest values of economic indicators released during this period did not show signs of weakening. This indicates that the current 50 basis points rate cut is more of a "precautionary" measure.

Moreover, core inflation in August rebounded slightly from July. Against this backdrop, the magnitude of the rate cut in September has broken the usual pace of 25 basis points rate cuts. We believe that this reflects a potential decrease in the weight of inflation, with the focus possibly shifting from inflation to employment.

After the normalization of the Beveridge Curve, the Federal Reserve ultimately has to choose between employment and inflation. In the past (May 2022 to January 2024), the verticalization of the Beveridge Curve provided a window for the labor market to cool down with "low unemployment rate," giving the Federal Reserve a reason to lower inflation without significantly increasing the unemployment rate.

The situation has now changed, with the Beveridge Curve starting to shift to the right, indicating a risk of continued deterioration in the unemployment rate while job vacancy rates continue to decline. This also means that after the normalization of the Beveridge Curve, with longer-lasting inflation resilience and longer-lasting unemployment, the Federal Reserve will ultimately have to choose one.

Subsequent rate cuts may focus more on stability. We believe that the main purpose of the Federal Reserve's precautionary rate cut this time is to prevent economic risks brought about by a rapid softening of the labor market.

There are two paths for the Federal Reserve's subsequent rate cuts: one is to continue with precautionary rate cuts, with smaller regular rate cuts focusing on stability; the other is to shift to recessionary rate cuts, with a significant rate cut after a clear economic downturn. Currently, we believe that the likelihood of continuing with a stability-focused rate cut pace is higher. Firstly, we expect that the unemployment rate at the end of this year will be similar to the economic forecast level in September. Secondly, the stubborn core inflation to some extent solidifies the pace of subsequent 25 basis points rate cuts.

Main Content

I. A shift in focus of the Federal Reserve's policy

The rate cut initiated at the September FOMC meeting has become a certainty, with the key being the magnitude of this rate cut—50 basis points.

The 50 basis points rate cut at the beginning is a "precautionary" rate cut. As of September 12th, the market's expectation for a rate cut was still mainly 25 basis points. The probability of a 50 basis points rate cut gradually increased between September 13th and September 17th. During this period, economic data released by the United States included the New York Fed manufacturing index, retail sales data, industrial output data, NAHB real estate market index, and more.

Based on these released economic indicators, their latest values were higher than the previous values, showing no significant signs of weakening. However, the market bet on a larger rate cut before the meeting. The meeting decision reflected this as well (policy rate range lowered to 4.75%-5.00%), indicating that the current 50 basis points rate cut is more of a "precautionary" measure The "precautionary" rate cut reveals a shift in policy focus or change behind it. In August, core inflation rebounded slightly from July. Under this inflation data, the rate cut in September broke the usual pace of 25 basis points, indicating a shift in policy focus from inflation to employment.

1. In the September economic forecast, the Federal Reserve lowered its expectations for economic growth, PCE, and core PCE, but raised its expectations for the unemployment rate (see Table 1). It is not difficult to see that the softening trend in the job market has caught the attention of the Federal Reserve (see Table 2). Furthermore, Federal Reserve Chairman Powell stated that if there had been employment data at the time, the Fed would likely have cut rates in July, reflecting a shift in the Fed's policy decision focus from inflation to employment.

2. The August U.S. CPI continued to decline, falling to 2.5%, but the overseas market's reaction to the decline in inflation was not enthusiastic. Even after the inflation data was released, CME still expected a 25 basis point rate cut. The main reason for the decline in inflation in August was the volatility caused by the energy component.

II. Normalization of the Beveridge Curve

The verticalization of the Beveridge Curve provides a window for "cooling down" the labor market with a "low unemployment rate". An increase in the job vacancy rate usually indicates labor market tightness, which may lead to companies raising wages to attract and retain talent, potentially pushing up inflation to some extent.

Conversely, a decrease in the job vacancy rate often accompanies a decline in inflation, but a softening job market is also reflected in the unemployment rate. In the past (May 2022 to January 2024), the "verticalization" of the Beveridge Curve was a reason why the Federal Reserve could reduce inflation without significantly increasing the unemployment rate.

The U.S. Beveridge Curve is rightward, beginning to normalize. The situation has changed now, with the job vacancy rate still trending downward, but the Beveridge Curve is starting to shift to the right, implying that the phase of "decreasing job vacancies" absorbing "rising unemployment rates" is coming to an end. This indicates that while the job vacancy rate continues to decline, there is a risk of further deterioration in the unemployment rate.

This also means that after the normalization of the Beveridge Curve, the Federal Reserve will ultimately have to choose between inflation and employment. Either tolerate a certain degree of increase in the unemployment rate in exchange for continued decline in inflation, or tolerate longer-lasting inflation resilience in exchange for maintaining a low unemployment rate.

From January to August this year, the unemployment rate rose from 3.7% to 4.2%, resulting in core inflation falling from 3.9% to 3.3%. We believe that the main purpose of the Fed's precautionary rate cut this time is to prevent economic risks brought about by a rapid softening of the job market. If the year-end unemployment rate is close to the Fed's expectations, the likelihood of a rapid rate cut is low

3. The pace of subsequent rate cuts may be more stable

We believe that the rate cut magnitude at the September meeting has led to the market's "running ahead" of expectations for subsequent rate cuts. If the economy does not show a significant decline, the pace of subsequent rate cuts will be more stable.

From the dot plot, Federal Reserve officials' rate range forecasts are mainly concentrated between 4.25% and 4.50%, compared to the current 4.75% to 5.00%, there is still a 50 bp rate cut space this year. However, CME is betting on a 25bp rate cut in November and a 50bp rate cut in December. With the U.S. economy slowing rather than entering a recession, the pace of rate cuts is more likely to be steady progress.

First, we expect that the year-end unemployment rate will be similar to the economic forecast level in September. The Federal Reserve initially focused on lowering inflation as the main target, and the current decrease in inflation has also cooled the job market. Looking at the current logic of the Federal Reserve focusing more on "stable employment," employment data has a greater impact on its path. Under the baseline scenario, we assume that the number of new jobs will decrease to zero by the end of 2025, corresponding to a monthly decrease of about 5100 people, which is greater than the current trend.

In this scenario, the unemployment rates at the end of 2024 and 2025 are around 4.3% and 5.6% respectively. Compared to the September economic forecast unemployment rate, it is only slightly higher than the end of 2024 (4.4%) by 0.1 percentage point. With the unemployment rate close to the Federal Reserve's expectations, the possibility of a "25bp-50bp" rate cut path in the future is unlikely.

Second, the stubborn core inflation to some extent solidifies the pace of a 25bp rate cut in the future. The breakdown of core service inflation mainly consists of two parts: housing service inflation and non-housing service inflation (closely related to the labor market). Based on our forecast of the job market, if the softening trend in the job market remains unchanged, non-housing service inflation may not show an upward trend again, and the focus of inflation is whether housing inflation may rebound.

Looking at changes in rent, the pressure of rent on inflation may fall on next year, and next year's core inflation resilience may also restrict the magnitude of rate cuts at the end of this year. This means that the closer we get to the end of this year, the more the rate cuts will affect next year, and the more cautious the preemptive rate cuts need to be.

There are two paths for the Federal Reserve's future rate cuts: one is to continue with preemptive rate cuts, which are smaller regular rate cuts, with a focus on stability; the other is to switch to recessionary rate cuts, with a significant rate cut after a clear economic downturn. Currently, we believe that the likelihood of continuing with a rate cut pace focused on stability is higher.

For the domestic market, the impact of the Federal Reserve's rate cuts mainly has two aspects: The opening of domestic monetary policy space is the first point. As of August, the year-on-year growth rate of domestic PPI remains negative, with real interest rates on the high side. There is a demand domestically to lower interest rates and reduce financing costs. In the early stages, due to the constraint of the Federal Reserve maintaining a high policy rate, the magnitude and space for interest rate cuts domestically were relatively restrained. However, after the Federal Reserve cut interest rates, the constraints on domestic reserve requirement ratio cuts and interest rate cuts are expected to be eased, which is a positive development for the domestic market.

The second point is that interest rate cuts will boost some overseas demand, providing support for China's exports. The Federal Reserve's initiation of an interest rate cut cycle is somewhat beneficial in hedging against economic downturn risks and supporting the resilience of Chinese exports.

Author: Xie Yunliang (S1500521040002), Mai Linyue, Source: Macro Bright Language, Original Title: "The Logic of a 50BP Interest Rate Cut: Beveridge Curve Returns to Normal | Xinda Macro"