The Federal Reserve will lower its policy interest rate later this month, as is nearly universally anticipated by analysts and financial market participants. But market expectations that the central bank will slash its federal-funds target range aggressively by a full percentage point or more by year end will probably prove to be excessive -- just as they were earlier this year.
Federal Reserve Chair Jerome Powell
Comments by key officials have made crystal clear that rate cuts are coming at the next meeting of the policy-setting Federal Open Market Committee, on Sept. 17-18. The employment report for August released on Friday morning all but clinched a reduction of 25 basis points (one-quarter percentage point) in the current fed-funds range of 5.25% to 5.50%. The latest data confirmed the recent trend of slower hiring -- but few firings.
That all but quashed earlier speculation of a 50-basis-point cut. Leaving aside the unique circumstance of 2020, when the economy was shut down by Covid-19, in this century the Fed has commenced easing monetary policy with a 50-basis-point cut only during times of financial market upheavals. These are notably absent now, with major stock market indexes hovering just below records and accommodative corporate credit conditions.
Following Friday's jobs report, fed-funds futures were placing a 75% probability of a 25-basis-point reduction of the Fed's key policy rate this month. August payrolls data again fell short of economists' projection, with negative revisions for the two prior months. But the unemployment rate, which is derived from a separate survey of households, ticked back down to 4.2%, reversing July's 0.1 percentage point rise.
Specifically, August's 142,000 increase in nonfarm payrolls came in light compared with economists' average guess of 161,000, while the two previous months' total were revised down by 86,000.
Offsetting the miss on payrolls was a rebound in the workweek to 34.3 hours, which Joseph Carson, former chief economist at AllianceBernstein, says is equivalent to hiring several hundred thousand workers. Average hourly earnings also rose 0.4% in the latest month, more than economists had guessed. "Companies do not lengthen the workweek and increase wages when economic conditions are soft," he added in an email.
But, as Fed Chair Jerome Powell emphasized in his keynote speech at last month's Kansas City Fed conference at Jackson Hole, Wyo., "we do not seek or welcome further cooling in labor market conditions."
And following Friday's employment release, Fed Gov. Christopher Wallach made it even clearer. "I believe the time has come to lower the target range for the federal-funds rate at our upcoming meeting," he said in a speech at the University of Notre Dame.
"Furthermore, I do not expect this first cut to be the last," he added. But how much and how fast the rate cuts will come will depend on the data. John Williams, the New York Fed president (which makes him the FOMC vice chair) had a similar message on Friday. Those will be the last Fed officials to speak for now,s as the quiet period ahead of the next FOMC meeting begins on Saturday.
The notion that the Fed might initiate the rate-reduction process with a 50-basis-point cut, which was forecast by a number of prominent bank economists, goes against recent history showing that such aggressive moves come in reaction to financial crises. The Fed did make such a move in January 2001, after the dot-com bubble had burst. And it cut 50 basis points in September 2007, when cracks already had begun to appear a year before Lehman Brothers went bust.
No such financial market strains are currently visible. While the S&P 500 index and the Nasdaq Composite had a bad week, they're still only a few percentage points from their highs. And investment-grade issuers brought a two-day record of $76 billion of fresh corporate debt to market on Tuesday and Wednesday, indicating vibrant credit conditions that hardly need any Fed accommodation.
To be sure, the beige book prepared for the coming FOMC meeting had a distinctly downbeat tone. Nine of the Fed districts reported weaker conditions, with only three saying that "economic activity grew slightly." Employers were only filling necessary vacancies or those resulting from attrition. But unemployment claims remain steady at a low level of about 230,000 per week, indicating no widespread sacking.
One obvious factor that seems to be overlooked by economists and investors is that this is an election year. A number of academic studies find that employers pull back on spending ahead of elections, especially when the races are expected to be close.
This year's presidential race may not be decided until well after Nov. 5. Just as important as who will occupy the White House is the makeup of Congress. The most likely outcome is a divided government next year, while the only certainty is the expiration of the Tax Cut and Jobs Act provisions on Dec. 31, 2025.
But if political uncertainty eases while the Fed lowers rates, the economy may be more likely to keep chugging along than fall into recession. That probably means that market expectations of sharper rate cuts once again will prove excessive, just as they were earlier this year.
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