The FOMC relieved the markets by cutting rates by 50 bp, the first rate cut since the pandemic. The markets were mostly content with the dovish policy decision even though they were not initially too happy with the economic outlook, as FOMC committee members project only an additional 50 bp cut this year and a modest rise in unemployment. In contrast, the bond market expects close to 75 bp cut by December. Here are the main takeaways from the FOMC statement, outlook, and press conference.
Table: Target rate probabilities for 2024-2025
As seen above, the updated target rates, based on the bond market, suggest that the FOMC were to cut rates by another 75bp by December, with a 42% chance of a 50 bp rate cut in November and a nearly 50% chance of another 50 bp in December. For the FOMC to cut rates by such numbers, the labor market would have to show much weaker signs than the FOMC currently expects, and inflation would need to come much more at a faster than currently expected.
The chart above shows that the FOMC revised down its outlook; again, however, it also raised its R*, which suggests that the FOMC expected it would need to cut less of its short-term policy rate before reaching the neutral rate – thus suggesting the current policy rate is not as constraining the economy as they thought it was before.
Concerns over the labor markets loom
This decision suggests the FOMC acknowledges it should have started cutting rates in late July, leading to a short-lived market tantrum. Before the September rate decision, the bond markets priced in a 60% chance of a 50 bp cut, and the FOMC delivered on its goal to support the economy, especially after the BLS revised down its estimates of the jobs added to the economy by over a million jobs, and as the unemployment is starting to tick up. Speaking of which, the FOMC revised its unemployment rate projections for this year from 4% to 4.4%; currently, it’s at 4.2%. The current level has trigged the Sahm rule, suggesting the US economy is in a recession. Still, as Sahm herself has pointed out, this rule of thumb should be taken with a grain of salt, given the complexity of the labor market in the post-pandemic era. In addition, while the rise in unemployment is due, in part, to immigration – thus raising the workers’ supply – the FOMC is adamant about avoiding a spike in unemployment, as pointed out by Powell in the press conference.
Inflation is still a concern, but less so
Jay Powell stated that inflation is still an issue that the FOMC hasn’t beaten, even as it is close to the Fed’s 2% target. Indeed, the recent CPI report indicated that headline CPI reached 2.5% and core CPI stood at 3.2%; both indices have been on a downward trend. So, while the FOMC isn’t ready to hang a “mission accomplished” banner, the 50 bp rate cut signals that the attention of the FOMC has shifted to the labor market.
What’s next?
The FOMC will continue to monitor the labor market and inflation. The labor market may show further signs of weakness that could trigger additional rate cuts in the coming meetings. However, the FOMC will probably move forward and consider more minor cuts of 25 bp, considering the lengthy inflation run the US economy has faced in recent years. Also, as Powell said in the meeting, the impact of the Fed’s policy changes tends to transmit to the real economy in a lag, so it will take time to evaluate how these decisions affected the economy, including the labor market. If inflationary pressures loom large, the FOMC isn’t likely to move quickly and cut rates by another 50 bp. The recent 50 bp cut mostly caught up with what the FOMC should have done in July – start cutting rates by 25 bp. The next meeting, which will be in early November, shortly after the US elections are held, could also be partly influenced by the results of the elections as fiscal policy could take a 180-degree turn that may push inflation back up – especially if the next president starts new trade wars and cut taxes. These policies could bring higher inflationary pressures, possibly leading the FOMC to readjust its policy rate trajectory.