Fed Preview- How the Fed will signal a potential September rate cut

The Federal Reserve is set to announce its interest rate decision tomorrow, and while it is widely expected that rates will remain unchanged, the central bank is likely to signal a potential rate cut in September. Despite falling inflation, rising unemployment, and increasing "real" interest rates, which all point towards the need for an immediate rate cut, the Fed seems to be using its statements and press conferences to prepare the market for a possible cut in the near future.

In the last Federal Open Market Committee (FOMC) statement, the Fed noted "modest further progress toward the Committee's 2 percent inflation objective." By potentially removing the word "modest" and the specific reference to price pressures, the Fed could signal that it views economic risks as more balanced, setting the stage for a future rate cut. Additionally, the phrase "Inflation has eased over the past year but remains elevated" could be softened by removing "elevated," further paving the way for a policy shift.

The debate within the Fed between hawks and doves continues to center around inflation and employment data. Hawks argue for maintaining higher rates to ensure inflation is fully controlled, while doves point to the recent rise in unemployment and other economic slowdowns as reasons to cut rates sooner rather than later. The recent uptick in initial jobless claims and the likelihood of the "Sahm Rule" being triggered by the end of the year suggest that the labor market risks are shifting to the downside.

Inflation, measured by Core PCE, has been incrementally "stickier" than the Fed would prefer, but it has been nearly a year since there was even a +0.1% uptick in the year-over-year rate. This suggests that inflation is gradually declining, which should give the Fed some leeway to consider the broader economic impacts of high-interest rates. The "real" interest rate, which accounts for inflation, is rising each month, making monetary policy incrementally tighter as the economy shows signs of slowing in the second half of the year.

The Fed's language in its statements and Chairman Jerome Powell's press conference will be closely scrutinized for signs of a potential September rate cut. By removing or adjusting certain adverbs and phrases, the Fed can indicate a shift in its stance without committing to an immediate rate cut. For example, changing the phrase "the Committee remains highly attentive to inflation risks" could signal a more balanced view of economic risks.

Despite some economists arguing that the Fed should cut rates immediately due to rising unemployment and cooling inflation, others believe the Fed should wait for more data to avoid repeating past mistakes. The unemployment rate, although rising, is still below the Fed’s estimates of the “natural” rate of unemployment, suggesting the labor market is not yet a significant concern for inflation.

The timing of the Fed's decision is also critical, as it will be announced just two days before a key Bureau of Labor Statistics report on unemployment. This report could provide further insight into whether the rise in unemployment is a blip or a trend. If the report shows a significant increase in unemployment, it could put additional pressure on the Fed to act sooner. However, for now, the Fed appears to be setting the stage for a potential rate cut in September, balancing the need to control inflation with the risks of a slowing economy.