I've been saying that there will be a rate cut in July! Be prepared for bigger fluctuations

After the latest non-farm payroll data "shocked" the market, it is gradually believed that the Federal Reserve's rate cut in September is too late. The global stock market sell-off this week has deepened this view, with traders even suggesting that the Fed should urgently cut rates to rescue the market. Two weeks ago, before the Fed announced its July rate decision, former New York Fed President Bill Dudley, who had shifted from a "dove" to a "hawk," directly called for an immediate rate cut. However, the Fed remains unmoved.

Today, he once again published a column emphasizing his views, suggesting that the Fed should cut rates immediately, although the likelihood is slim, and the market should be prepared for greater volatility in stocks and bonds. The following is the full content:

Has the Fed gone too far in fighting inflation, leading the world's largest economy, the United States, into a destructive recession?

This unsettling question has shaken the global markets out of their long-term calm. More turbulence is expected before the answer emerges.

Two weeks ago, I shifted from a hawk to a dove, abandoning support for higher rates and advocating for an immediate rate cut to avoid an economic downturn. It turns out that a rate cut in July was not early enough. Since then, evidence of a weak labor market and slowing inflation has quickly accumulated, strongly indicating that the Fed is behind the curve.

Of particular note is that the three-month average unemployment rate has risen to 4.13%, an increase of 53 basis points from the lowest level in the previous 12 months. This has breached the 50 basis points threshold indicated by the Sam rule, indicating that the U.S. is heading into a recession with a significant rise in unemployment.

In addition, wage growth has slowed as recruitment and quit rates decline, while initial and continued claims for unemployment benefits have increased. In terms of inflation, the Fed's preferred gauge, the PCE, maintained a good month-on-month growth rate for the third consecutive time in June, rising only 0.2% from May. Average hourly earnings in July grew by 3.6% year-on-year, down from 3.8% in June, consistent with the trend of slowing in the Employment Cost Index for the second quarter.

Many economists, including Claudia Sahm, the founder of the Sam rule, believe that the Sam rule may not apply this time: strong labor force growth is driving the rise in unemployment, rather than an increase in layoffs. When asked about this rule, Fed Chair Powell once said, "I call it a statistical regularity... It's not like an economic rule that can tell you what might happen."

They may be right, but I wouldn't base monetary policy on such assumptions. The Sam rule had a good predictive effect in the late 1960s and 1970s when the labor force was growing rapidly. It reflects a fundamental economic process: a deteriorating labor market tends to self-reinforce. Unemployed individuals and those worried about unemployment reduce spending, leading to further cuts in hiring by businesses. When the threshold of the Sam rule is breached, the unemployment rate always continues to rise, with an increase from the trough to the peak of nearly 2 percentage points at a minimum. So, what should the Federal Reserve do? The longer the wait, the greater the potential damage: the already tight monetary policy becomes even tighter as price and wage inflation slow down. Interest rates need to be lowered to a neutral level. Members of the Federal Open Market Committee estimate the range of neutral interest rates to be between 2.4% and 3.8% (I personally believe it is in the upper half of this range). This means that the current actual federal funds rate of 5.3% is much higher than the neutral level. If an economic recession becomes a reality, the Federal Reserve will need to adopt an accommodative policy and lower rates to 3% or lower.

Immediate rate cuts are reasonable, but not very likely. This does not align with Chairman Powell's cautious approach, and the Federal Reserve rarely takes such action outside of regular policy meetings unless there is a severe shock that significantly alters economic prospects or threatens financial stability.

The next Federal Reserve meeting is scheduled for September 17th to 18th, where they may cut rates by 25 or 50 basis points, depending on the economic data performance leading up to that time. The path beyond that is unclear, with a possible series of 25 basis point rate cuts, eventually bringing rates below 4%. If the "Sam Rule" holds, rates may be lowered even more steeply to stimulate levels.

The uncertainty surrounding the trajectory of monetary policy may remain at a high level in the coming months. Therefore, be prepared for greater volatility in the stock and bond markets