The Fed has signaled that it will cut the Federal Funds target range 25bp (to 5.00-5.25%) on September 18 and initiate a monetary easing program. While nascent growth concerns could dovetail with excessive labor market cooling to motivate a larger initial reduction, more assertive forward guidance appears likely instead.
17 SEP 2024
Edward von der Schmidt
Key Takeaways
Based on its recent communications, the Fed appears most likely to cut 25bp at the September FOMC meeting while signaling future accommodation consistent with an easing program (i.e., cutting at least 25bp at every meeting in the near term – inflation-permitting).
FOMC participants will presumably discuss larger rate reductions but may reserve them for future meetings should employment or broader economic conditions necessitate accelerated easing measures. Regardless, forward guidance concerning the near-term path of policy rates will be more important than the size of the first cut.
The Fed is not done with inflation. Anchoring long-term expectations remains critical to achieving price objectives. While not anticipated at present, persistent inflation pressures have the potential to temper the pace of future easing. The Fed will proceed deliberately and preserve flexibility in order to reinforce its commitment to both sides of its mandate.
Overall risks to the outlook have shifted to the downside. Economic activity has flattened or declined in the majority of Federal Reserve districts as of three weeks ago. A confluence of employment and growth concerns could merit a 50bp initial cut and accelerated easing. A 50bp reduction would indicate that conditions have deteriorated faster than the Fed had anticipated.
1. The Fed's Balancing Act
"The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates."
At a glance, the Federal Reserve’s remit appears simple. Often referred to as its ‘dual mandate’, the central bank’s statutory responsibility is actually three-fold: “promoting maximum employment, stable prices, and moderate long-term interest rates”. In practice, addressing employment and inflation typically satisfies the third condition. The Fed is chiefly concerned with the evolution of labor markets and price levels over time.
Given their varying and dynamic interdependence, the employment and inflation objectives cannot be addressed in isolation. Moreover, the Fed has one primary tool (and many complementary ones) at its disposal – the target range for the Federal Funds rate. The latter is the unsecured (i.e., without collateral) cost of borrowing balances held at the Federal Reserve overnight among banks and other eligible institutions. Notwithstanding the comparatively limited scope of the “fed funds” market, this policy lever establishes a universal benchmark for financing and discount rates that affect financial markets and communities across the world. Policy adjustments are not a tool that the Fed wields lightly.
Inflation, or the rate at which prices increase over time, is a monetary phenomenon lending itself to a more precise goal. The Fed targets an inflation rate of 2 percent annually, as determined by their preferred gauge of prices – personal consumption expenditures – and seeks to keep longer-term expectations anchored near that level. If enough people believe that inflation will persist above 2 percent, that can become self-fulfilling and mitigate the effectiveness of policy or compel higher-than-necessary interest rates.
Naturally, financing conditions bear consequences for the real economy, including decisions whether to spend, invest, or hire. In this manner the Fed strives to indirectly influence labor market conditions. By lowering interest rates, for example, more accommodative financial conditions can facilitate economic activity conducive to labor growth. Such conditions depend on the effective transmission of monetary policy through to the real economy, however, and may bring attendant inflation risks. The Federal Reserve’s policy deliberations are defined by this balancing act, which we are witnessing at present. The difficulty for the Fed lies in assessing its progress toward both its employment and inflation objectives while accounting for uncertainty and monetary policy lags.
In contrast to inflation, “the maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors”. In order to pursue maximum employment consistent with its price objectives, the Fed might seek to address perceived shortfalls by loosening policy. Employment conditions giving rise to above-target inflation might warrant more restrictive policy instead. The Fed “considers a wide range of indicators” – a totality, if you will – in order to assess labor market conditions and the appropriate monetary policy stance.
The FOMC and Federal Reserve Chair Powell have repeated that future monetary policy decisions will depend on "incoming data, the evolving outlook, and the balance of risks". Broad as it may be, this framing encapsulates the inherent uncertainty of complex, dynamic systems that comprise our domestic and global economies. The Fed evaluates incoming data as a proxy for the state of labor markets and prices generally and then estimates the most likely paths for each. From here, the Fed can assess how such projected evolutions might present risks to the Fed’s objectives down the road. This is a necessarily subjective and imprecise exercise – no matter the specificity desired by markets.
2. Communicating Clearly
"The Committee seeks to explain its monetary policy decisions to the public as clearly as possible."
It might be tempting to consult myriad economic and financial figures and experts to deduce what the Fed perceives in order to model likely policy paths. Alternatively, we could consider the guidance immediately following the statutory mandate:
“The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.”
If our aim is to better understand the Fed’s perspective and intentions, we might listen to what they say.
The statement issued upon the conclusion of every FOMC meeting is the most direct, deliberate signal that the Fed communicates. Differences from one statement to the next shed light on the central bank’s evolving assessments of employment and inflation, progress toward statutory mandates, and the outlook for monetary policy. Signals conveyed through official channels regarding future policy paths constitute forward guidance, a powerful tool in its own right. In addition to taking action in the present, the Fed can influence our understanding of what it intends or expects to do in the future. If the outlook is sufficiently uncertain (as it often is), it may not be prudent or possible to articulate policy too far in advance. Still, the Fed does not intend to surprise.
The Fed also endeavors to communicate important context that will shape its policy deliberations. Consider subtle changes to how the Fed characterized prevailing conditions on June 12 and July 31:
Topic | June FOMC | July FOMC |
Economic Activity | "continued to expand at a solid pace" | " |
Job Gains | "remained strong" | "moderated" |
Unemployment Rate | "has moved up but remains low" | " |
Inflation | "elevated" | "somewhat elevated" |
In its meeting statements, the Fed’s assessment of economic activity and unemployment did not substantively change from June to July, but labor market strength diminished in tandem with disinflation – a slowing rate of price increases. Nevertheless, inflation remained above target and the Fed sought “greater confidence that inflation is moving sustainably toward 2 percent”. The Fed does not need to wait for inflation to reach 2 percent to cut rates – that would almost certainly be too late. Instead, the Fed must be confident that inflation appears to be headed that way in reasonable time.
How will we know if the Fed sees inflation moving sustainably toward 2 percent? They might simply tell us directly in the statement (released at 2pm ET), or the Chair could make that assessment clear in his prepared remarks or responses at the FOMC press conference (beginning at 2:30pm ET). We can also look for clues in the Summary of Economic Projections (SEP), home of the “dot plot” and other estimates released quarterly along with the meeting statement. The SEP is a compilation of each FOMC participant’s “best-guess” individual forecasts. These projections offer a dispersion of estimates that can hint at shifting expectations among the Committee; they are best interpreted in broad strokes.
In the June SEP for example, near-term inflation forecasts were marked higher than in March, but median forecasts for year-end 2026 and later anticipated a return to the 2 percent target. We can also see that participants envisioned scope for 200-250 basis points of interest rate cuts through 2026. These individual policy rate projections are not inconsistent with the imminent shift signaled by the July 31 FOMC statement and Chair Powell in the press conference (and later in his Jackson Hole speech).
One quarter (three months) of acceptable inflation was simply not enough time to establish sufficient confidence in disinflationary trends in order to begin easing. In June, employment risks were also conspicuously absent from the statement: “[…] the Committee remain[ed] highly attentive to inflation risks”. While the July statement emphasized that the Fed “remains strongly committed to returning inflation to its 2 percent objective”, cooling labor markets stoked concerns about the Fed’s maximum employment objective and labor conditions compelled discussion of a 25bp rate reduction. Tellingly, a 50bp cut was not even considered.
With the FOMC “attentive to the risks to both sides of its dual mandate”, the Fed has collectively and repeatedly acknowledged that less restrictive policy will be appropriate. Put differently, an easing program is imminent. Labor market deceleration has made it clear to the Fed that it is time to go. The question remains: how quickly?
3. Tweaking the Message
"We do not seek or welcome further cooling in labor market conditions."
In determining the appropriate policy stance, FOMC participants consider a “wide range of information”, including:
“readings on labor market conditions”
“inflation pressures and inflation expectations”
“financial and international developments”
Between FOMC meetings, incoming data influences expectations of how the policy outlook might be evolving as well as assessments of risks to the Fed’s employment and inflation mandates. Federal Reserve officials often speak to these contemporaneous developments directly. There is also considerable discretion applied to the FOMC meeting minutes that are typically released three weeks after each meeting.
Not coincidentally, Chair Powell shared that Federal Reserve officials allow for a few weeks to evaluate the efficacy of policy signaling before reorienting communications as necessary. Accordingly, the July 31 FOMC meeting minutes (released August 21) dedicated considerably more attention to recent labor market deterioration. In choosing to emphasize employment considerations, the Fed confirmed that labor markets were on their minds in July. These concerns appear to have superseded inflation in their immediacy, thus tilting the balance of risks in favor of more accommodative policy in September.
Chair Powell addressed this plainly in his prepared remarks given at the Kansas City Fed’s annual Jackson Hole symposium ("Reassessing the Effectiveness and Transmission of Monetary Policy"). Juxtaposed with significant declines in inflation, “[t]he labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic”. This assessment is weaker than how Powell characterized labor markets at the July 31 press conference.
Without raising the alarm on employment broadly, Powell conceded that “the cooling in labor market conditions is unmistakable”. He pointedly added, “We do not seek or welcome further cooling in labor market conditions”. Such a posture motivated Powell to state clearly that “[t]he time has come for policy to adjust” and that the “direction of travel is clear”. This is as close as the Fed gets to confirming a policy shift in advance of a meeting and Committee vote. In another time, Fed adjustments could come without warning. Today, we have come to expect the central bank to follow a predetermined schedule, which they have obliged.
4. Policy Heads or Tailwinds
"[t]he timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks"
Inflation remains “somewhat elevated”. Powell has repeatedly emphasized the importance of maintaining well-anchored inflation expectations in order to satisfy the central bank’s price objectives. Notwithstanding employment considerations calling for a September 18 cut, the Chair eschewed specific forward guidance beyond telegraphing a policy pivot: “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks”. Given an uncertain economic outlook, the Fed has chosen to maintain policy flexibility beyond signaling the onset of monetary easing. Only a 25bp cut was discussed at the July meeting, and the Fed has said little to dissuade that notion.
Is a 50bp cut possible Wednesday? Absolutely. Is it merited? Arguably. Have official communications or Chair Powell’s recent public remarks referred to or implied a 50bp rate reduction to begin easing? Not once. While the Fed is free to change course at its discretion, ensuring smooth implementation and transmission while minimizing policy uncertainty encourages setting appropriate expectations in advance. The Fed needs good reason to surprise.
The Fed’s goal to “explain its monetary policy decisions to the public as clearly as possible” does not only apply after the fact. Filter the cacophony of markets and ask whether conditions have changed enough in the last month to establish new trends and warrant a material departure from what the Fed has deliberately communicated thus far. Reasonable people may arrive at different conclusions.
An initial cut greater than 25bp would imply a substantially worse assessment of employment and economic conditions than conveyed in July and August. On one hand, recent labor market indicators including the August employment report and household survey challenge the notion of outright weakness. On the other, economic growth that had appeared “solid” until very recently could be turning. The August Beige Book report released on September 4 highlighted flat or declining activity in the majority of districts, a development that will undoubtedly prompt discussion among FOMC participants.
Nevertheless, a case for 25bp could still be made. Such a forecast downgrade as would be signaled by a 50bp cut might invite a counterproductive tightening of financial conditions. Moreover, the Fed must assuage inflation concerns as it begins to cut rates in order to anchor expectations as it eases – a non-trivial task. Considering the Fed’s repeated emphasis on inflation, which remains “somewhat-elevated”, a larger-than-signaled cut could send mixed messages.
Another consideration involves the scope for future rate reductions. Chair Powell has maintained that neutral policy rates are presumably higher than during the inter-crisis period of the 2010s. In the June 12 SEP, upper Federal Funds rate target forecasts mostly settled between 3.00% and 3.50% at the end of 2026 and 2.50% to 3.00% longer-term. For reference, the current target range is 5.25-5.50%.
A 25bp cut on September 18 would not just be consistent with “an appropriate dialing back of policy restraint” in the context of balanced risks (an admittedly critical assumption). Even a modest target range reduction will propagate and compound in future periods. Policy target changes do not just affect the current period but the entire term structure of rates - accommodative forward guidance will only amplify these effects. If the Fed were to set preliminary expectations for 25bp rate cuts at each FOMC meeting in the near-term – a year say – as appears likely, that cadence would double the median easing pace anticipated in June.
Signaling steady rate reductions ahead – something like 200bp of cuts within a year (i.e., eight meetings, 25bp per meeting) – would be more accommodative than a larger reduction lacking clear forward guidance and inviting further outlook uncertainty. Such an intended path would lend relief to intermediate financing rates, where credit pressures can be particularly acute. All the while, the Fed would reserve the right to pause or accelerate easing as needed in November and beyond. Our collective preoccupation with the size of the initial cut in September while ignoring the importance and efficacy of forward guidance may miss the forest for the trees.
*A Word on Market-Implied Policy Expectations
We often hear about what markets collectively “expect” the Fed to do with a granularity that belies real-world uncertainty. Policy expectations derived from publicly-traded securities such as futures contracts are implied – they are not pure projections as might be submitted in survey responses. No arbitrage conditions – the same risk-adjusted cash flows should command the same price, also known as the Law of One Price – determine these implied paths.
In the table above, fed funds futures markets imply ~150bp of cuts over the next four meetings, including September, and at least one 50bp or 75bp cut in November or December. Only further guidance from the Fed at the conclusion of Wednesday's meeting can corroborate expectations for an uneven easing path. Based on Fed signaling, this is possible but would require an unexpected downgrade to the Fed's outlook from just a few weeks ago - when implied levels were similar.
While market-implied policy rates should roughly correspond with actual policy expectations, they need not do so. Large trading flows, positioning imbalances, financing bases, collateral needs, statutory requirements, short-term supply, foreign currency hedging – myriad factors influence the prices of front-end securities used to derive implied policy expectations. In short, there can be significant noise.
The best way to read and anticipate the Fed is to focus on what they communicate. Though the future may be in flux, the Fed is actively trying to help us understand what it is doing and why.
Sources
Statement on Longer-Run Goals and Monetary Policy Strategy
FOMC statements, press conferences, minutes, and Summary of Economic Projections
Semiannual Monetary Policy Report to the Congress
Chair Powell’s interview at the Economic Club of Washington
Kansas City Fed 2024 Jackson Hole Economic Symposium
Chicago Mercantile Exchange
This is not financial advice and should not be taken as such. The observations and opinions expressed here are protected by copyright and belong to Datum Research LLC. All rights reserved.