The labor market has slowed down, is a 25 basis point rate cut by the Federal Reserve in September really enough?

The Federal Reserve is preparing to start easing its tightening policy this month, as inflation cools and the labor market slows. A major issue policymakers are facing now is whether a 25 basis point rate cut can keep the economy in expansion.

The non-farm payroll report released last Friday showed that the pace of hiring in the United States has slowed over the past three months, dropping to the lowest level since the outbreak of the pandemic in 2020. Nevertheless, these numbers still cast doubt on whether Fed officials will opt for a significant rate cut at the meeting on September 17-18.

The report has set the stage for intense debate within the Fed, with officials like Fed Chair Powell possibly leaning towards a substantial rate cut to ensure the Fed does not fall behind the curve, while others are still hesitant about a 25 basis point cut, according to Diane Swonk, chief economist at Grant Thornton.

Under Powell's leadership, the Fed made the mistake of acting too slowly, leading to the most serious inflation surge since the early 1980s going unchecked, weakening the purchasing power of American households. If they act too slowly this time, they could cause an increase in the unemployment rate and push the economy into a recession.

Swonk said, "Powell must be thinking about his political legacy now, he must truly achieve a soft landing."

The choice facing Fed officials is whether to gradually ease or make a significant rate cut, a decision that is bound to be controversial and often occurs during major shifts in monetary policy.

With most economic indicators now trending downwards, some economists believe that taking cautious measures poses a greater risk than taking proactive action. As consumer spending decreases, a rise in the unemployment rate can quickly become self-reinforcing, leading to more layoffs. The unemployment rate has already risen by nearly a percentage point from its low point last year, triggering a recession indicator known as the "Sam Rule".

"This raises some serious questions, not only about this meeting, but also about the coming months," Chicago Fed President Evans said last Friday. "How do we work to prevent things from getting worse?"

Another report released by the U.S. Bureau of Labor Statistics on September 4 showed that job openings in July fell to the lowest level since early 2021. The ratio of job openings to unemployed persons—which had reached as high as 2:1 during the peak labor shortage period of the pandemic—has now fallen to about 1:1.

These two reports follow Powell's remarks on August 23, where he stated at a conference in Jackson Hole, Wyoming that he and his colleagues "are not seeking nor welcoming further cooling of labor market conditions".

"Powell is trying to steer the Fed towards a dovish direction," said Tim Duy, chief U.S. economist at SGH Macro Advisors. "If the economy unexpectedly slows and rates are too high, the economy will not be able to adjust to that situation."

Last Friday, the employment report initially led investors to increase bets on a 50 basis point Fed rate cut, causing significant market volatility. Hours later, Fed Governor Waller suggested that a 50 basis point cut is unlikely before more data is released in the coming months, leading to a reduction in these bets The U.S. government will release two additional non-farm payroll reports between the Federal Reserve's September policy meeting and the next meeting on November 6th to 7th. Investors are currently optimistic about the possibility of a 50 basis point rate cut at the November and December meetings.

"The Fed tends to take a gradual approach," said Stephen Juneau, an economist at Bank of America. "If economic activity remains strong, they do not want to send the wrong signal to the market. Overall, the U.S. economy still seems to be performing well."

If the Fed cuts rates by 25 basis points this month and by 50 basis points in November and December, it would bring the target range for the federal funds rate down to 4% to 4.25%. However, this level is still well above the "neutral" level that most Fed officials believe, putting pressure on economic activity.

Inflation Risks

In recent weeks, some Fed officials have expressed concerns that if the Fed cuts rates too quickly and stimulates economic activity, there could be upside risks to inflation. The Fed's preferred inflation gauge, the core PCE price index, remains at 2.5%, slightly above its 2% target.

These policymakers also point to the trend of layoffs, noting that while hiring has slowed, the layoff rate remains low.

"History tells us that prematurely easing monetary policy is a dangerous gamble that could reignite inflation and persist in the economy for months or even years," wrote Atlanta Fed President Bostic in an article on September 4th.

For Powell, the risk of a slowdown in the labor market threatens an extraordinary achievement the Fed has made so far - a soft landing. In 2022 and 2023, the Fed embarked on its most aggressive tightening cycle in 40 years to curb inflation. Achieving a reasonable level of inflation without triggering a recession would be a rare accomplishment.

And achieving this goal may depend on the upcoming rounds of rate decisions. Neil Dutta, Chief Economist at Renaissance Macro Research, said:

"The Fed should act when the rise in the unemployment rate is relatively modest, rather than waiting until it becomes so obvious that it's already too late."