Federal Reserve policymakers received fresh confirmation last Friday that inflation is continuing to ease, paving the way for a potential interest rate reduction as early as next month. As inflationary pressures subside, the Fed’s focus is shifting towards preventing further cooling in the labour market, which has shown signs of softening.
The Commerce Department reported that the Personal Consumption Expenditures (PCE) price index, the Fed’s preferred inflation gauge, rose 2.5% in July from a year earlier, maintaining the same pace as in June. Over the past three months, the annualized reading on the PCE index has remained well below the Fed’s 2% target, signaling that inflation is largely under control. This has led Fed Chair Jerome Powell to suggest that “the time has come” to cut interest rates, following a period of aggressive rate hikes in 2022 and 2023 aimed at combating decades-high inflation. The central bank has kept its policy rate steady in the 5.25%-5.50% range since last July.
Ben Ayers, Senior Economist at Nationwide, wrote that “recent price trends confirm that the end of the Fed’s inflation fight is coming into view,” making a rate cut at the upcoming September 17-18 policy meeting likely. Ayers also noted that the further cooling of inflation could give the Fed more room to be aggressive with rate cuts in future meetings, especially if the labour market continues to deteriorate.
Despite the positive inflation data, the labour market has become a growing concern for the Fed. The unemployment rate has risen nearly a full percentage point to 4.3% since the Fed stopped raising rates more than a year ago. While this is still low by historical standards, it is enough for Powell to declare that the Fed would not welcome any further weakening in the job market. Economists at Evercore ISI have described the situation as a shift from an “inflation-first Fed to a labour-first Fed,” underscoring the central bank’s new priority.
Traders are currently betting that the Fed will begin with a quarter-percentage-point rate reduction in September, but there is speculation that a larger half-percentage-point cut could be in the cards at a later meeting. Financial markets are pricing in a full percentage point cut by the end of the year, although most analysts predict a slightly less aggressive approach, depending on the strength of the economy and labour market data.
Looking ahead, the focus of both investors and the Fed will be on key economic data releases before the September meeting, including the U.S. government’s employment report for August and the Consumer Price Index (CPI) report for the same month. These reports will play a critical role in determining the Fed’s next steps.
The U.S. economy grew at a slightly stronger pace in the second quarter than initially reported, with Gross Domestic Product (GDP) rising at a 3% annualized rate during the April-June period, up from the previous estimate of 2.8%. This growth was driven by an upward revision to consumer spending, which advanced 2.9%, more than the prior estimate of 2.3%. However, other areas of the economy, including business spending, inventories, and residential investment, showed signs of weakness.
The Gross Domestic Income (GDI), another key measure of economic activity, rose a more moderate 1.3% in the second quarter, matching the first-quarter gain. While GDP measures spending on goods and services, GDI measures the income generated from producing those same goods and services. The average of the two growth measures was 2.1%, indicating that growth has cooled so far this year after accelerating in the second half of 2023.
As the Fed prepares to lower interest rates, the easing of inflation is expected to provide some relief to sectors like housing and manufacturing, which have been heavily impacted by high borrowing costs. However, the labour market’s health will be the key factor in determining how aggressive the Fed will be with rate cuts moving forward.
In the meantime, corporate profits remain in the spotlight, with adjusted pre-tax profits rising 1.7% in the second quarter. The debate over corporate profits has become a focal point on the campaign trail, with Vice President Kamala Harris proposing new measures aimed at increasing taxes on corporations and high-income individuals, while former President Donald Trump has pledged fresh tax cuts to bolster the economy.
As the Fed navigates this complex economic landscape, its dual mandate of promoting maximum employment and stable prices will be tested. The coming months will be crucial in determining the direction of U.S. monetary policy as the central bank seeks to balance the need for economic growth with the challenges of a cooling labor market.