Fulfilling dual mandates, the Federal Reserve faces a dilemma: which is a greater risk, weak employment or terrifying inflation?

With inflation cooling down and potential signs of weakness in the labor market, Federal Reserve officials have generally reached a consensus: it's almost time to lower interest rates. Investors share the same view, with the market fully pricing in an expected 25 basis point rate cut at the September meeting of the Federal Open Market Committee (FOMC).

However, some media analysis suggests that as U.S. monetary policy approaches a key turning point, the coming months may be tense, with Federal Reserve Chairman Powell and his colleagues now facing a choice between two opposing risks. While they aim to completely eliminate the threat of inflation, they also want to lower rates at the right time and pace to prevent a rapid deterioration in the labor market.

The focus of the market's attention is how quickly the Fed will cut rates after September, with concerns that moving too slowly could pose greater risks.

"They are not just considering the first two rate cuts, but the overall strategy for the next six to nine months," said Derek Tang, economist at LH Meyer/Monetary Policy Analytics. "Officials are asking: where do we want to be if shocks are on the horizon?"

This indicates that the Fed may adopt a risk management strategy, which is often used by the Fed in periods of high uncertainty. In other words, they will look at two objectives, assess where the greater risks lie, and tend to address the larger risk first while keeping an eye on the other risk.

Disagreements within the FOMC

However, analysts believe that achieving this is not easy. Despite the Fed keeping the benchmark interest rate in the range of 5.25% to 5.5% for over a year, with inflation cooling down, real interest rates have been rising. With slowing job growth and cooling inflation, there are disagreements within the FOMC on where the greatest risks lie.

Among them, Fed Governor Bowman and Atlanta Fed President Bostic advocate for a gradual rate cut, hoping to see more evidence that price stability is in place and still believe that the labor market has some resilience. They point out that part of the reason for the rise in the unemployment rate is job seekers re-entering the labor market. Additionally, despite companies reducing hiring, there has not been widespread layoffs.

For this camp, analysts point out that Powell can refer to the July inflation report to show that a 25 basis point rate cut in September is unlikely to trigger price increases. Excluding food and energy, the Consumer Price Index rose 0.2% month-on-month in July, with the annualized figure increasing by 1.6%, the lowest level since February 2021.

The unemployment rate has now risen to 4.3%, so there are officials concerned about the labor market, setting some kind of "red line" for the unemployment rate. This camp includes San Francisco Fed President Daly, who stated on August 5th, "We have now confirmed that the labor market is slowing down, and it is extremely important that we do not let it slow down excessively, leading to an economic downturn." Analysis suggests that in recent years, the U.S. economy has greatly benefited from a tight labor market, attracting many people to enter the labor force and raising wages, helping individuals withstand inflation. However, this situation may quickly reverse, as the rise in the unemployment rate from 3.7% in January to 4.3% in July this year indicates that if the economy slows down excessively, the unemployment rate may continue to rise. Wage growth has already slowed down, and the unemployment rates for African Americans and Latinos have increased since the end of last year.

"The FOMC intentionally slowed down the pace of economic growth to release the excessive pressure in the economy," said David Wilcox, former chief forecaster of the Federal Reserve and current director of the American Economic Research Institute at the Atlantic. "In this environment of weak growth, this vulnerability will surface."

Ensuring an economic soft landing is Powell's top priority, which may also involve his personal legacy. At the same time, the credibility of the Federal Reserve is also being tested. Powell and his colleagues responded slowly to the surge in inflation, initially calling it "transitory." If an economic recession occurs due to prolonged high interest rates, it would mean missing out on opportunities on the other hand, undoubtedly angering both parties in Congress and affecting public sentiment.

Risk Management Strategy

Powell has hinted that he will adopt a risk management approach to help him navigate the coming months. When considering the consequences of making mistakes in two directions, history shows that the greater risk may lie in employment. In addition to the COVID-19 pandemic, the recent recession has had a profound and lasting impact on the labor market, especially on low-income workers, as some have exited the labor force, with some permanently leaving.

Given this, analysts believe that the Federal Reserve may not only communicate a path for interest rates to return to some form of balance or neutral level for the economy, but also a path aimed at offsetting risks of higher costs. The market has already hedged against the latter possibility, with pricing indicating a nearly one percentage point rate cut by the end of the year.

"The current major risk is that the weakness in the labor market may accelerate, leading to an unnecessary economic recession," Wilcox said. "A 50 basis point rate cut should be the basic expectation for their first move. The labor market does not need to soften further."