The Fed needs to act

The Fed is finally meeting next week to decide about an interest rate cut. It is about time as the economy has already slowed down during the summer. Payrolls rose 142K in August, but downward revisions amounting to 86K fewer jobs over the prior two months took some shine off the increase. Payrolls are now up just 116K on average over the past three months, a marked deceleration of the 207K average monthly pace in the first half of the year. The unemployment rate did, however, tick down a tenth to 4.2% and average hourly earnings came in a bit hot, rising 0.4%. The economy is still adding jobs, and the August report alone is not a large problem, but the recent direction of travel for hiring is a concern for growth.

While many market participants were counting on the August jobs report to sort out the debate of whether the Fed eases by 25 bps or 50 bps at its September policy meeting, it does not alone overwhelmingly support either option. The labor market has normalized and is no longer exerting upward pressure on inflation, which that means the Fed no longer needs to be in such a restrictive policy stance. While a 25 bps cut may still be the base view of many Fed officials, the Fed may elect to slash rates a larger 50 bps amid uneasiness around recent labor market deterioration. Bottom line is that the Fed is notorious for being too slow to react and to use bold moves, and it seems to be the case again. Some even call them incompetent.

In looking beyond the labor market, some areas of the economy are struggling under the weight of the Fed’s restrictive policy. Construction spending slipped 0.3% in July and has lost momentum over the past year as elevated financing costs narrow the pipeline of new projects. Manufacturing activity is also still in a rut, and it has been for months. While the composite manufacturing index rose last month, it remains consistent with a sector in contraction and was boosted by what appears to be at least a partially unintended build in inventories. New manufacturing orders fell to the lowest reading since May of last year, signaling the demand environment remains grim. The Fed should take notice.

Yet, even as some areas struggle, service sector activity remains in good shape, demonstrated with the modest uptick in the ISM reading for August and the string of optimistic purchasing manager comments that included mention of business being stable, good, strong or improving. Resilient consumer spending continues to prop up service sector activity and recent data generally suggest the U.S. economy is tracking to rise north of a 2% annualized rate in the third quarter. After all, the U.S. economy is built on consumerism and capitalism and more shopping is good for the economy, regardless of use of credit cards, loans, or cash.  

Recession risk is elevated today, but it is not yet the base case. The economy, and thereby hiring, has slowed from the breakneck pace in recent years, but data are still not consistent with broad economic contraction. Despite this, it is time for the Fed to shift from a restrictive to neutral policy stance, which should offset additional economic cooling.

While the center of gravity has shifted toward the labor market, inflation’s bumpy descent to the Federal Reserve’s 2% objective is ongoing. It is expected that the overall CPI will increase 0.2% in August, which would push the year-over-year rate down to 2.6%, a level not seen since March 2021. Still too high though. A large drop in gasoline prices points to an outright decline in energy costs, while food inflation appears little changed. Excluding food and energy, the core CPI is expected to increase 0.25% in August, which would be the largest increase in four months and would keep the year-over-year rate unchanged at 3.2%.

Market participants universally expect an easing of monetary policy on Sept. 18. The only question is by how much: 25 bps or 50 bps? It is time a 50 bps reduction in the target range for the federal funds rate. This is still not a bold move, as rates could be cut even further, but the slow-moving Fed would still be on the right track with a 50 bps cut.

Regardless of the size of the rate cut at the upcoming meeting, the Fed will ease significantly in the coming months. The stance of monetary policy is quite restrictive at present. The Fed needs to cut the nominal fed funds rate considerably in coming months to get back to neutral. Otherwise, Federal Reserve policymakers risk driving the economy into recession with an overly tight stance of monetary policy. We currently look for the Committee to cut rates by 200 bps by mid-2025 (chart). The spread between the yields on the 10-year Treasury and the 2-year Treasury notes, a popular recession indicator, turned positive for the first time in 26 months recently.

The Fed needs to act now, and they need to act decisively with a bold interest rate cut to get the American economy going again. They should already have done this, but as expected, they decided to wait and enjoy the summer vacations first. Hopefully they will cut 50 bps with more to come during the fall.