Labor Market Becomes New Focus, Fed Ready for September Rate Cut

As policymakers grow increasingly confident that price stability is within reach, and with rising risks in the labor market, the Federal Reserve is ready to cut rates in September. Fed Chair Jerome Powell may make this clearer at the policy meeting on July 30-31.

However, this is not set in stone. Fed officials still want to see inflation continue to decline towards the 2% target before committing to lowering the benchmark rate from its 20-year high. Meanwhile, Powell and his colleagues are determined not to waste the opportunity for a soft landing of the U.S. economy, which has shown signs of losing momentum.

Fed officials are shifting their focus from inflation to the labor market. Powell said in the House of Representatives on July 10, It's not just about reducing inflation. We need to pay attention to the state of the labor market.

The Fed's preferred inflation measure has fallen to 2.6%, and the once-overheated labor market has slowed to pre-pandemic levels. While Fed officials continue to describe the labor market as strong, they also indicate that it may be approaching a turning point as job vacancies steadily decline and the unemployment rate gradually rises.

Fed Governor Waller said on Wednesday, I do believe we are getting closer to the point where we have a reason to lower rates. He noted that the labor market is in an optimal position, but the Fed needs to maintain this position, adding, The risk of rising unemployment is greater than we have seen for a long time.

Most Fed officials have not disclosed the exact timing of the first rate cut, but economists and investors interpret their remarks as a signal for a September rate cut. Jonathan Pingle, chief U.S. economist at UBS, said, There is strong momentum within the Federal Open Market Committee (FOMC) to cut rates in September. You can see that many areas of the labor market are cooling, which were previously performing strongly.San Francisco Fed President Daly said that the cracks in the labor market have not yet reached the level requiring immediate action, but she also acknowledged that the situation could change quickly. Daly stated, We don't want to see the labor market start to weaken significantly and become shaky because by then, it's often too late to restore employment.

Chicago Fed President Goolsbee said on Thursday that the central bank may need to lower borrowing costs soon to prevent the labor market, which has been cooling in recent months, from further deteriorating. Goolsbee pointed out that while the Fed is still addressing inflation, several months of data improvements have convinced him that officials are back on track to reduce inflation to the 2% target. However, he emphasized that the labor market is definitely an area of concern because maintaining high interest rates while price pressures ease means substantial tightening of monetary policy.

U.S. job vacancies, which hit record highs during the pandemic, have now fallen back to 2019 levels. While hiring remains stable, it has slowed and is more concentrated in a few industries.

The U.S. unemployment rate has risen month by month over the past three months, reaching 4.1% in June. While still at historical lows, it is the highest level since 2021. Wage growth has also slowed. Fed Governor Cook said on July 10 that the Fed is very attentive to the unemployment rate and will respond if it worsens further.

The rebalancing of the U.S. labor market has been accompanied by a slowdown in consumer spending as high prices and borrowing costs weigh on consumers. In the Fed's latest Beige Book, which compiles observations of business conditions across the 12 regional Federal Reserve Banks, nearly half of the regions reported flat or declining economic activity, and business expectations for future growth were subdued.

Although Fed officials continue to emphasize that policy will be guided by forthcoming aggregate data, they recognize that maintaining the current stance amid slowing inflation effectively amounts to tightening.

Fed officials used terms like encouraging and very good to describe recent inflation data, reinforcing their belief that inflation is on the right track. Powell said earlier this week that last quarter's data indeed boosted confidence to some extent.

Policymakers also stressed the need for more information before making the significant decision to cut rates. New York Fed President Williams said on Wednesday, We will actually learn a lot between July and September.

Investors have fully priced in a Fed rate cut in September. Since the end of last month, the yield on the two-year Treasury note, which is sensitive to Fed policy, has plunged about 30 basis points.

However, Republican presidential candidate Trump has said the Fed should not cut rates before the election. North Dakota Republican Senator Kevin Cramer stated that any policy move before November could create bad optics.

Early communication from Fed officials may also help explain the rationale to the public—an important task given the political sensitivity of a rate cut less than two months before the U.S. election.

Stephanie Roth, chief economist at Wolfe Research, said, The risk now is that high interest rates will lead to a real slowdown in the labor market. And because of political concerns, the Fed wants to convey this message.

When asked how the U.S. election might affect the timing of a rate cut, Fed officials emphasized they would not get involved in politics. The Fed even included a special section on independence and transparency in its semi-annual report to Congress earlier this month.

Powell and his colleagues have conveyed that the Fed will ignore the election timetable and take the measures most beneficial to the economy. Daly said, It's time to focus on our dual mandate. As we manage risks, we must focus on both aspects to achieve sustainable price stability and full employment.