Fed interest rate resolution is coming!

The Federal Reserve will announce its interest rate resolution at 2 p.m. local time on Wednesday (2 a.m. GMT on Thursday). Most Fed watchers expect that the Fed will not ease monetary policy this week, but policymakers will prepare for a rate cut in September.

Fed officials said they are increasingly confident that inflation will continue to fall to the 2% target. Fed officials are also increasingly concerned about the rising unemployment rate, another sign that a rate cut may be on the horizon.

But most Fed watchers say the Fed still needs more time to make sure inflation cools off while also preparing the market for a major upcoming move.

“They're under increasing pressure,” said former Kansas City Fed president Esther George. “I think they're going to be thinking very seriously about policy in September. We're coming up to a more important time in my view to make that decision, and that's why I'm more confident.”

The latest data showed the annual rise in the core personal consumption expenditures (PCE) index, the Fed's favorite inflation gauge, fell to its lowest level in more than three years, providing renewed evidence that a rate cut could be imminent. US core PCE rose 2.6 percent year-on-year in June, unchanged from May and down from 2.8 in April.

Another inflation indicator, the Consumer Price Index (CPI), also showed progress. The core CPI, which excludes food and energy prices, rose 3.3 per cent year-on-year in June, down from 3.4 per cent in May and 3.6 percent in April.

Luke Tilley, chief economist at the Wilmington Trust, said that as a result, at the end of this week's policy meeting, “the Fed will say that recent economic data, particularly inflation data, leads them to believe that inflation is likely to return to target levels and that a rate cut would be appropriate.”

Still waiting

Some Fed watchers do believe the Fed has a case to support a rate cut at this week's meeting, although they don't expect it to happen.

“I can't find a reason in the economic data for them not to cut rates at this meeting,” Tilley said. “In fact, I think it's hard to find a reason why they should leave rates unchanged.”

Nonetheless, the Fed is “unlikely” to cut rates because of the risk of “spooking the markets,” Tilley added. He expects one rate cut in September and one in December, and then a total of six cuts in 2025 of 25 basis points each.

A rate cut this week would take the market completely by surprise. Traders now expect only a 5 percent chance of a rate cut this week, compared to a nearly 100 percent chance of a cut at the 17-18 September meeting.

But Goldman Sachs chief economist Jan Hatzius also believes there is a strong case for a rate cut in July.

Hatzius said, “If the case for a rate cut is clear, why wait another seven weeks to implement it？”

“Second, monthly inflation is highly volatile and there is always the risk of a temporary re-acceleration, which could make a rate cut in September difficult to explain. A rate cut from July would avoid this risk.”

Another reason a rate cut in September is more likely is that Fed officials have said they need more than one-quarter of good data to be sure inflation is moving in the right direction. They may want to look at July and August data first.

George said, “I think they will strongly emphasize that September may be the right time, but they will have to be careful with their wording so that they don't commit without seeing the August data.”

“Walking the tightrope”

Another factor that could influence when the Fed cuts rates is a cooling labor market. The unemployment rate has risen to 4.1 percent for the second month in a row, higher than some Fed officials expect by the end of the year.

This is important because the Fed has a dual mission to maximize employment in the US while maintaining price stability. Fed Chairman Jerome Powell has made it clear that as inflation declines, the Fed will focus more on the labor side of the mandate.

Chicago Fed President Austan Goolsbee said earlier this month that the cooling job market was “worrisome” and “needs to be watched closely”.

He added that while there are other warning signs, so far it doesn't look like the start of a recession. Rather, it looks more like the labor market is returning to a more balanced state after the shock of the epidemic.

Tilley doesn't see the job market getting worse going forward. He expects the unemployment rate to rise from the current 4.1 percent to 4.5 percent by the end of this year as more people enter the job market for the first time, those who had left it re-enter it and others lose their jobs.

But George doesn't think a soft landing is on the cards, and she thinks a recession will come sooner or later. She says the momentum of people joining the job market is starting to wane, which suggests the economy is slowing down.

In an election year, “if you let unemployment go up for reasons that don't seem to have much to do with inflation, I think that sends a tough message to the public,” she added. “It would be like walking a tightrope for them.”

There are concerns that the Fed could actually maintain too tight a monetary policy for too long, leading to a recession.

According to Tilley, “The Fed has a history of keeping rates too tight for long periods, which might trigger a recession, and then after the recession bottoms out, the Fed keeps rates too low.”

But this week's policy poses no risk to the economy as long as the Fed signals a September rate cut that will lead to lower government bond yields and borrowing rates.

However, a September action could lead to the Fed facing political criticism from both sides of the US aisle.

If the Fed leaves rates unchanged in September, calls from Democrats for a rate cut could reach a crescendo. However, if the Fed cuts rates in September, Republicans, including Donald Trump, are sure to see the move as bowing to election-year pressure.

Trump reiterated earlier this month that the Federal Reserve should not loosen monetary policy before the November election.

Trump said, “They know they shouldn't do that.”