Top three officials of the Federal Reserve turn dovish again: The "crazy journey" of the Federal Reserve is just beginning, with a possible 50 basis point rate cut in the September meeting

Former "Fed's No. 3" William Dudley, who served as the President of the New York Fed from 2009 to 2018, once again issued dovish signals after two weeks.

On Wednesday, August 7th, Eastern Time, Dudley published a column titled "The Fed's Crazy Journey Has Just Begun," warning that in order to avoid an economic recession, the Fed may cut interest rates by a larger-than-expected margin at the next meeting in September.

Wall Street News previously mentioned that Dudley, who had called for Fed rate hikes in 2019, made a 180-degree turn two weeks ago, shifting from a staunch hawk to a dove, urging the Fed to act now and preferably decide on a rate cut at the end of July meeting. He believed that waiting until September to cut rates would increase the risk of an economic recession. Dudley pointed out an unsettling signal in the economy: the three-month average unemployment rate has risen by 0.43 percentage points from its low point in the previous 12 months, very close to the 0.5 threshold set by the Sam rule. If it exceeds 0.5%, it indicates an economic recession.

At that time, Dudley pointed out that Fed officials misunderstood the labor market and were not very concerned about the risk of the unemployment rate breaking the Sam rule. They believed that the rise in the unemployment rate was due to rapid labor force growth, not increased layoffs. However, this logic was not convincing. The Sam rule accurately predicted the economic recession in the 1970s when the US labor force was also growing rapidly. Historical evidence shows that the cooling of the labor market tends to decline more rapidly, and delaying rate cuts increases the risk of recession.

In his column on Wednesday, Dudley stated that in the past two weeks, more evidence has shown that the US labor market is weakening, while inflation is further slowing down. He once again mentioned the warning signal of the unemployment level, stating that the three-month average unemployment rate has reached 4.13%, 0.53 percentage points higher than the lowest level in the previous 12 months. This exceeds the 0.5% threshold defined by the Sam rule, indicating an economic recession in the US, with future unemployment rates set to rise significantly. He also mentioned that the Fed's favorite inflation indicator, the core PCE price index, increased by 0.2% month-on-month in June, marking three consecutive months of moderate growth.

Recently, many economists, including the creator of the Sam rule, former Fed economist Claudia Sahm, believe that the Sam rule may not necessarily apply this time. In other words, the increase in the unemployment rate this time is driven not by layoffs but by an increase in labor supply. Sahm stated that the Sam rule has somewhat failed and cannot prove that the US economy has entered a recession. At the press conference after the Fed meeting at the end of July, Fed Chairman Powell was asked about the Sam rule and he stated that he would refer to the rule as a statistical regularity, not an economic rule that can tell you what might happen.

In his article on Wednesday, Dudley wrote that the views of the economists mentioned above may be correct, but he would not formulate monetary policy based on this assumption. The Sam rule reflects a fundamental economic process: that a deteriorating labor market tends to reinforce itself. Once the threshold of the Sam rule is breached, the unemployment rate always rises significantly The minimum increase from the trough to the peak is close to 2 percentage points. In such a situation, what should the Federal Reserve do?

Dudley believes that the longer the Federal Reserve delays cutting interest rates, the greater the potential damage. Federal Reserve policymakers expect the neutral interest rate level to be between 2.4% and 3.8%, which means that the current effective federal funds rate of 5.3% is still far from the neutral level. If the United States does indeed fall into an economic recession, the Federal Reserve will need to cut rates to 3% or lower. While the Fed could cut rates immediately, the likelihood is low as it does not align with Powell's cautious approach. The Federal Reserve rarely takes emergency action outside of regular policy meetings unless the U.S. faces a severe shock that significantly alters the economic outlook or threatens financial stability.

Therefore, Dudley speculates that at the monetary policy meeting in September, the Federal Reserve may decide to cut rates by 25 or 50 basis points, with the specific magnitude depending on economic data between now and then. The interest rate path after September is still unclear, but it could involve a series of gradual 25 basis point rate cuts, eventually bringing the policy rate below 4%, or a significant rate cut if the Taylor Rule prediction is accurate.

Dudley warns at the end of the article that the outlook for Federal Reserve monetary policy in the coming months may remain highly uncertain. Therefore, both the stock market and bond market are likely to experience more volatility, and everyone should be prepared for significant fluctuations