The FOMC left interest rates unchanged today as expected and suggested that conditions for a cut could be achieved as soon as September. However, Fed officials indicated that they would remain data-dependent and still required more confidence that inflation has eased enough to begin cutting, meaning September is not a done deal.

On the one hand, Fed officials say that the labor market is in better balance, but it is wary of material further weakening, which could prompt a September start, in our view. On the other hand, the Fed says that while it has made material progress towards slowing inflation, it has not fully achieved the price stability aspect of its dual mandate, which could take September off of the table.

For now, we anticipate at least two 25 basis point rate reductions before the end of this year, with a higher likelihood of a cut in September.

Trusted Insights for What’s Ahead™

• Policymakers further opened the door for a September cut, stating that, “In recent months, there has been some further progress toward the Committee's 2 percent inflation objective.”
• However, the Fed stopped well short of saying that a September reduction is absolute, reiterating that, “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
• Grounds for a September cut would need to be solidified by upcoming data, including this week’s employment report, and additional updates on CPI and PCE inflation.
• Recent data suggest that the Fed still has room and even some cause to continue waiting before cutting interest rates, given concerns about reigniting inflation.
• But policymakers also fear waiting too long to cut rates, risking doing serious damage to GDP growth and the labor market.
• We continue to anticipate that economic conditions will allow for at least two 25 basis point rate cuts before the end of this year.
• Still, the Fed may not engage in successive cuts at every meeting after the first action, leading to a protracted decline in rates to a new normal that is likely to be above the pre-pandemic average.

Fed Signals vs. Our Take

The Fed was not ready to cut interest rates at today’s July FOMC meeting, and while a September cut might be possible, it is not guaranteed. Incoming data ahead of the September 18 meeting on inflation and the labor market, and likely also tracking GDP inputs, will be critical to the Fed’s decision to being moderating its restrictive monetary policy stance. The Fed’s data-dependence probably will keep markets in limbo near-term.

The Economy Giving Mixed Messages

In the policy statement, the FOMC highlighted the mixed messages the economy is giving in recent data, which is complicating the monetary policy calculus: “Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have moderated, and the unemployment rate has moved up but remains low. Inflation has eased over the past year but remains somewhat elevated.” Our own view of incoming economic data matches much of the Fed’s assessment:

• Inflation has improved, but it is still above target and several factors including wages are hindering the return to the Fed’s 2-percent target (see Inflation Slows But Not Enough for July Cut).
• Some aspects of the US economy are slowing under the weight of higher interest rates, but other aspects are remaining resilient – especially consumer spending within private domestic demand – and contributing to inflation (see Q2 GDP Growth Supports Rate Cuts This Year).
• The labor market has downshifted but from raging to robust. The unemployment rate is higher this year relative to last year but remains incredibly low. Moreover, wages continue to be sticky due to persistent labor shortages and are putting upward pressure on inflation (see Labor Market Downshifts From Raging to Robust).
• Importantly, the US economy does not appear to be in recession or headed towards one, which lessens the need for the Fed to cut quickly or by a lot per meeting.
• However, the Fed likely is very close to the Goldilocks economy it desires to warrant the beginning of interest rate cuts.

What will it take for cuts to commence?

The Fed’s bias is towards cutting rates, but the question is when. Chair Powell said the conditions might be right in September, but also indicated that many questions remain.

The Fed Chair outlined the case for cutting rates as well as the case for remaining on hold.

He indicated that to cut, inflation would have to move down quickly or more-or-less in-line with policymakers’ expectations, accompanied by reasonably strong growth and a labor market consistent with its current conditions. The Chair said that the labor market is “strong” but there is a real concern about potential downside risks to the labor market. Specifically, policymakers did not want to see further material slowing in the labor market. To remain on hold, inflation would have to be stickier or higher, and this would have to be weighed against activity in the labor market, growth, and the balance of risks.

On balance, the Chair indicated that the central bank wishes to carefully calibrate the timing and extent of interest rate cuts such that it does not reignite inflation nor crush the economy. Additionally, ahead of September, the Fed is completely data-dependent and looking for the “totality of data” to be released over the next seven weeks to strongly convince the FOMC to cut.

The Fed’s Dilemma

The Fed must now weigh the risks of cutting too soon or waiting too long. Cutting too soon could reinvigorate inflation, but going to late could cause undue damage to the economy.

Against these concerns, the Fed believes that its work regarding the dual mandate of maximum employment and price stability is coming closer into balance. The labor market has transitioned from overheated to “normal conditions,” and inflation is improving. To the latter point, the Fed Chair added that the job is not done regarding the inflation mandate, but the time is approaching to begin dialing back some of the restrictiveness. Moreover, the economy appears neither overheated nor weak, in his view.

Still, the central bank desires to see “more good data” across key inflation categories (i.e., goods, housing, and core services) to feel fully confident about cuts. Additionally, the Fed remains wary of providing any forward guidance about when cuts would commence, the pace of further actions, or the size of individual reductions given continued uncertainty about the economic outlook.

So, What’s Next?

We posit that if the labor market stays where it is or transitions from robust to weak, according to the July and August employment reports, and inflation gauges continued to slow in July, then the Fed will cut in September. While real GDP growth and financial conditions are not a part of the Fed’s dual mandate, a subdued retail sales report, abysmal housing data, and powerful financial market expectations of an imminent reduction, likely would also contribute to pushing the Fed to cut in September.

However, if payrolls gains are outsized, the unemployment rate ticks downward, wages remain sticky, and inflation progress stalls, then the Fed might wait until November to cut to be sure. Food and energy prices remain wildcards, and shelter costs are still only gradually easing. Additionally, a spike in retail sales or a collapse in the mortgage rate on the back of today’s meeting that leads to a flurry of inflation-inducing housing activity might also prompt the Fed to remain on the sidelines for somewhat longer.

When the Fed does begin to cut rates, we doubt that it will lay out any clear pace or magnitude for subsequent reductions. Cuts could come in fits and starts. Cutting too much, too quickly might undo the good work done so far to cool inflation to current levels. Ultimately, the fed funds rate next year and in 2026 will be lower than it is today. But the end of the rate cutting exercise may potentially leave nominal interest rates in the range of 2.5 to 3.5 percent, which would be higher than the 1.5 percent nominal (-0.5 percent real) average that prevailed over the period between the Great Financial Crisis and the Pandemic.

We will update our US forecasts and fed funds rate path within the next few weeks.