Fed prepares cut amid contradictions

Federal Reserve officials are expected to cut interest rates by a quarter of a percentage point on Thursday because inflation has continued to make progress towards their 2 per cent goal.

Officials began lowering rates at their meeting in September by making a larger half-point cut.

They are trying to figure out where, exactly, rates should settle after high inflation over the past three years led to a dramatic series of rate increases.

“We’re entering this new phase: Policy is going to become less restrictive over time, and that’s because the Fed is more confident on where inflation is going – that it’s going back down to 2 per cent,” said Loretta Mester, who retired as Cleveland Fed president in June after 10 years in the job.

This week’s meeting should lack the suspense of the prior one, in which markets were left guessing over the size of the first rate cut in four years.

Officials would like to avoid the spotlight because their meeting concludes two days after the presidential election, and the Fed strives to maintain an apolitical DNA.

The election also prompted the Fed to push back its meeting by a day. The central bank typically concludes its two-day meetings on Wednesdays.

While this week’s meeting may lack drama, officials face potentially thorny debates in the months to come.

First is the decision on where rates should settle. Second, while the election result won’t influence this week’s decision, any policy changes by the next president and Congress that reshape the economic outlook could also alter the Fed’s interest-rate path.

Policymakers face a stubborn economic puzzle that could influence whether they will feel pressure to slow down or speed up rate cuts in the months ahead – the labour market continues to show signs of cooling, but consumer spending has been solid.

Economic data released last week put an exclamation point on this riddle.

The economy grew at a solid 2.8 per cent annualised rate in the July September quarter, buoyed by consumer spending that has defied expectations of a slowdown for the past year.

Some economists have pointed to such resilience as a sign that the Fed’s rate stance isn’t as tight as some officials think it is.

At the same time, demand for labour has steadily cooled. The private sector added just 67,000 jobs a month, on average, for the three months to the end of October, the lowest since the pandemic hit in 2020.

While the unemployment rate held steady at 4.1 per cent last month, the share of workers who were permanently laid off ticked up to its highest level of the year, one of several signs pointing to less demand for workers.

It isn’t clear how long these trends – steady consumption with a slowing labour market – can last.

In one scenario, stronger consumer spending will continue to help stabilise the labour market because it will maintain solid demand for workers. In that more optimistic circumstance, the recent cooling in the labour market would reflect a post-pandemic normalisation and the Fed would be able to make fewer rate cuts.

More ominously, further weakness in income growth could weigh on consumer spending in the months to come, making the economy more vulnerable to a slowdown and potentially calling for more cuts.

Officials are also navigating through a fog of volatile data that has been revised from one month to the next. Several officials characterised the September rate cut as appropriate because inflation had fallen notably.

In the run-up to that meeting, the unemployment rate had ticked up to 4.3 per cent in July and payroll growth had slowed. At the time, consumers had appeared to be spending down their savings to propel growth.

But revisions to government data after the meeting showed income growth had been stronger than initially reported. As a result, the personal savings rate was revised upward, meaning consumers might not be as tapped out.

The revision “removes a downside risk to the economy,” Fed chair Jerome Powell said at a conference on September 30.

“These were very large, healthy revisions.”

Mr Powell suggested solid readings on economic activity could make officials somewhat more comfortable at the margins that the economy isn’t deteriorating. Still, he said labour-market data had historically provided “a better real-time picture” of the economy than data on gross domestic product.

Two whiplash labour-market reports followed. Last month, the Labour Department reported that job growth had been stronger than expected in July and August, and payroll gains were exceptionally strong for September.

That led to speculation that the Fed might need to consider slowing down the pace of future rate cuts.

Last week, employment figures for August and September were revised lower. Moreover, payroll growth was much weaker than anticipated in October – some likely caused by strikes and hurricanes.

In the run-up to this week’s meeting, officials had cautioned against significantly rethinking their interest-rate outlook on the basis of any single monthly report.

“I’ve been saying we should expect the data to be – what I’ve been using is, ‘janky,’ to bounce around a bit,” Atlanta Fed president Raphael Bostic said last month.

“We may get ‘janky’ reports from time to time, and the question will be, ‘Do they signal a new trend?’”

Fed officials are likely to proceed with a quarter-point cut this week in part because they are trying to set policy based on their forecast that inflation will continue to decline. Inflation has slowed over the past year as prices of energy and goods have fallen.

Mr Bostic said the right approach was to “remain patient and embrace the choppiness … in building a strategy and figuring out where things should go”.

This article first appeared in The Australian.