The Fed has opened the door to rate cuts in September! The first "test" is coming soon

Federal Reserve Chairman Powell hinted that unless inflation progress stalls, the Fed will cut interest rates in September, citing risks of further weakness in the labor market.

Powell stated that policymakers are getting closer to lowering borrowing costs from their highest levels in over two decades, highlighting the Fed's growing confidence in easing economic constraints. However, he cautiously mentioned that if price data in the coming months disappoint, the Fed would agree to cut rates.

Former New York Fed President Dudley said, "The changes in the statement and press conference basically tell you that there will be a rate cut in September unless there is a significant change in the economic outlook."

The Federal Open Market Committee on Thursday kept the federal funds rate in the range of 5.25% to 5.5%, a level that has been consistent since July last year.

Powell told reporters, "The question will be whether the overall picture of the data, evolving outlook, and balance of risks are consistent with the confidence in inflation and labor market stability. If so, our policy rate may be lowered at the next meeting in September."

The adjustments in the post-meeting statement and Powell's comments underscored policymakers' increasing concerns about excessive weakening in the labor market, marking a shift from their focus on inflation over the past two years.

Policymakers wrote, "The economic outlook is uncertain, and the Committee is closely monitoring risks on both sides of its dual mandate." Previously, their language leaned more towards inflation risks.

Powell described the labor market as solid but slowing, with hiring slowing down and the unemployment rate rising to 4.1%, the highest level since 2021 but still historically low. Layoffs remain rare. However, he stated that the labor market does not need to soften further for the Fed to achieve its 2% inflation target. Powell said in the press conference:

"We have seen a significant decline in inflation while the unemployment rate remains low," adding that this is an unusual and welcome outcome. "What we have been thinking about is how to sustain this situation."

Is the Labor Market Now a Top Priority?

The Fed is determined to lower inflation without triggering a recession, but Powell also emphasized the delicate balance between cutting rates too early or too late. By potentially starting rate cuts in September before inflation fully returns to 2%, they may establish some "safeguards" to prevent a significant deterioration in the labor market.

Powell said, "The inflation issue is not resolved yet, but nevertheless, we can start reducing the constraints imposed by the policy rate."

Elevating labor market risks to the same level as inflation reflects the dual pressure of politics and economics on the Fed.

As 2% inflation is about to be achieved, the rise in the unemployment rate, especially after the Fed acted too slowly as inflation rose, not only invites criticism but also damages the Fed's credibility with the public.

The market took this news in stride, with U.S. Treasuries rising after Powell's press conference. Rate futures show that traders have fully priced in the expectation of a 25 basis point rate cut in September and a total of nearly 70 basis points of rate cuts this year Chief Economist Diane Swonk of KPMG said, "Unless there is a significant reversal in inflation data, a rate cut in September will not be ruled out."

However, a rate cut in September is not set in stone. Although the inflation measured by the Fed's preferred indicator rose 2.5% in the 12 months ending in June and has been on a downward trend, policymakers are concerned that inflation may stagnate as it did earlier this year. Powell stated that he "can imagine a scenario where the number of rate cuts for the rest of the year depends on the way the economy evolves."

Analyst Nicholas Jasinski pointed out that the path of rate cuts by the Fed has never been clearer since the pandemic in 2020, and this rate cut path will face its first test on Friday.

First is the release of the July non-farm payroll data on Friday, with the market expecting an increase of 175,000 jobs in July, compared to an increase of 206,000 jobs in June; the unemployment rate is expected to remain unchanged at 4.1%. The August employment data will be released on September 6.

As for inflation data, the next two dates are August 14 and 30, when the CPI and PCE data for July will be released respectively. Officials will also see the August CPI data on September 11 before the FOMC meeting on September 17-18. The August PCE data will be released on September 27. Nela Richardson, Chief Economist at ADP, said:

"This is a Fed that wants to give itself as much optionality as possible, and the worst place for the Fed to be is backed into a corner. The Fed's saving grace is that the unemployment rate remains low, so they can afford to wait."