Rate cuts will only increase, not decrease? The Fed's focus shifts significantly!

With three weeks to go until the September interest rate decision by the Federal Reserve, the CME FedWatch tool shows that the market unanimously expects the Fed to cut rates by at least 25 basis points. This Friday, investors will gain the next clue about the future monetary policy path through the July US PCE inflation data. Additionally, the August non-farm payroll report will be released next Friday. The market believes that the importance of employment data will surpass inflation.

Regardless of how the PCE data performs, Art Hogan, Chief Market Strategist at B. Riley Wealth Management, believes that the Fed will definitely cut rates in September. In a recent interview, he stated, "They have turned this page for us, and Chairman Powell made it clear in his speech at Jackson Hole."

"Therefore, with the market continuing to rise but inflation continuing to fall, we are very confident that the Fed will cut rates on September 19th and may continue to cut rates over the next 18 months."

Due to concerns about slowing economic growth and the optimistic sentiment of easing inflation on Wall Street, investors have been calling for the Fed to cut rates as soon as possible. Barclays pointed out that in the six months following the first rate cut by the Fed, the average return of the S&P 500 index exceeded 5%. One year later, the return rate expanded to nearly 10%. Global derivative strategist Stefano Pascale also wrote:

"Historically, in the absence of a recession, when a rate-cutting cycle begins, the US stock market experiences an impressive rebound, and unless there are any recent surprises, this should also be the case this time."

Employment is cooling off even if it doesn't deteriorate

Federal Reserve officials have made it clear that they will shift their focus from inflation to at least equally focusing on employment, and the latest data shows that their concerns are justified. Various indicators indicate that the labor market is slowing down even if it is not deteriorating completely.

History shows that once the unemployment rate starts to rise, the speed will be rapid. "The Fed should be concerned." said Troy Ludtka, Senior US Economist at SMBC Nikko Securities. "The gears have been set in motion."

"When the unemployment rate goes down, take the stairs; when it goes up, take the elevator."

On Tuesday, the US Conference Board released its monthly Consumer Confidence Survey, the latest sign of trouble in the job market. While the overall data for August showed slight improvement, the labor market situation depicted in the survey is not as optimistic. The proportion of respondents who believe that job opportunities are "plentiful" has slightly decreased to 32.8%, while the proportion of respondents who believe that job opportunities are "hard to get" has risen to 16.4%. The gap between the two has narrowed to 16.4 percentage points, which is more than 30 percentage points lower than the peak of 47.1 percentage points in March 2022. He said: "This magnitude of decline often occurs when the economy enters a recession and the unemployment rate rises." Ludtka added that if historical trends hold, the gap between the two is more in line with a 4.8% unemployment rate, half a percentage point higher than July's rate.

Previously, the US Department of Labor reported a mere 114,000 increase in non-farm payrolls in July. Last week, the department also revealed in its preliminary estimates that it had overestimated job growth from April 2023 to March 2024, revising it down by 818,000, the largest annual revision in 15 years.

Increased Importance of Employment to the Fed

Of course, the Fed is not pleased with these two pieces of news, as it needs to balance its dual mandate of full employment and price stability. With inflation gradually falling to 2%, Fed officials have been emphasizing recently that the risks to the dual mandate are becoming more balanced, while also stressing the need for policies not to be too strict to avoid stifling the job market and endangering the broader economy. Previously, the Fed had been focused on lowering inflation that hit a 40-year peak two years ago.

A 4.3% unemployment rate is 0.8 percentage points higher than July 2023's 3.5%. According to the so-called "Sam Rule," this increase in the unemployment rate signals an impending economic recession in the US, although the US economy is still growing.

Fed Chair Powell expressed some concerns about the employment situation in his highly anticipated speech at Jackson Hole last week, stating that hiring has "cooled significantly" and pointing out that "we are not seeking or welcoming further cooling in labor market conditions."

"The Fed's focus will be on employment," said Beth Ann Bovino, chief economist at Union Bank. "Families have reason to be disappointed. It's a huge job market, and now it's becoming more balanced. That doesn't feel good. Before, you had five offers, now you only get one. That's the frustration out there."

Companies are still retaining employees, but they are pulling back on hiring for these positions. Job vacancies have indeed decreased, dropping to 8.2 million in June, nearly 1 million lower than a year ago and 4 million lower than the historical peak in March 2022. However, the current level is still much higher than before the outbreak of the COVID-19 pandemic, with every unemployed person still corresponding to 1.2 job openings.

San Francisco Fed President Daly stated earlier this week, "We haven't seen any deterioration in the labor market," but she still expects the Fed to start cutting rates soon.

Future Rate Cuts Depend on Employment Performance

The market expects a 100% chance of the first rate cut in September, and the question now is the speed and magnitude of the rate cut, which may largely depend on the health of the labor market rather than the latest PCE inflation data released on Friday.

In their latest forecasts submitted in June, Fed officials indicated that they expect the unemployment rate to remain stable in 2026 and beyond. In fact, in the long run, the unemployment rate is expected to decrease slightly to 4.2%. However, there is almost no historical precedent to suggest that this will be the case. Unemployment rates almost always either rise or fall, with little evidence to suggest that the unemployment rate will remain stagnant in the long term The next non-farm payroll report will be released on September 6th. Data from FactSet shows that although the unemployment rate is expected to drop to 4.2% in August, the current momentum is still on the rise. Non-farm employment is expected to increase by 175,000. However, SMBC Nikko predicts that the unemployment rate will reach around 5% within a year, which may force the Federal Reserve to adopt a more aggressive rate cut stance.

Former Cleveland Fed President Mester said on Tuesday, "In conversations with businesses, I find that... the labor market doesn't look healthy... it's slowing down. It will be a challenge to adjust monetary policy while ensuring that you don't ignore the fact that inflation has not yet returned to 2%," she added, "Balancing the risks of the two statutory missions is what is happening now, and it's new."