Fed’s rate-cut plans pre-empt a recession, rather than reacting to one
The Federal Reserve’s latest move is a shift from the hold-steady, wait-and-see approach to an aggressive defence of the US labour market
US STOCKS initially gained after the US Federal Reserve cut interest rates for the first time since December and signalled more cuts to come, but the rally soon faded as chairman Jerome Powell warned that tariff-fuelled inflation could still spoil those plans.
It was more than all but the most optimistic of Wall Street prognosticators had hoped for: a shift from the hold-steady, wait-and-see approach to an aggressive defence of the US labour market.
On Wednesday (Sep 17), the Fed cut its benchmark overnight lending rate by a quarter of a percentage point to a new range of between 4 per cent and 4.25 per cent. It also reduced the anticipated rate at the end of the year to around 3.6 per cent, citing the emerging risks to jobs growth.
There was only one dissenter: US President Donald Trump’s Fed appointee Stephen Miran, who called for a more drastic 50-basis-point cut. Trump, who is currently on a state visit in the UK, has yet to weigh in on the Fed’s latest decision, but he had previously called for a cut four times as large.
One brokerage said there was a disconnect between the Fed’s predictions of rising inflation and an uptick in economic growth, and the new rate-cutting stance.
“(Most Fed) policymakers are focused on getting ahead of downside risks to the labour market,” said economists at Bank of America Global Research. “But if the base case in the (economic projections) materialises, we think the Fed might end up having over-eased.”
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Most economists had viewed Powell’s refusal to cut rates earlier in the year as a sign that he would not stomach another series of rate cuts until inflation had been vanquished.
Powell himself had said he was merely waiting for the effects of tariffs to become clearer. And yet, he stated at his press conference on Wednesday that the full impact of those tariffs was yet to be fully known.
So far, tariffs have driven up product prices substantially, masking a drop in the prices of services and housing, he said.
Historically, product prices tend to fall over time, even adjusting for quality, he noted. After the post-pandemic bout of inflation, that trend had started to re-establish itself in 2024. This year, as tariffs took effect, product inflation has picked up again, which is a direct result of the duties.
The challenge for policymakers this time is to figure out whether the jobs slowdown or rising inflation is the bigger problem, Powell said.
The jobs market is in a “curious balance”, he added. The supply of workers has dwindled due to immigration clampdowns, and at the same time that demand for workers has dropped.
The August jobs report suggested that demand is falling below the break-even rate that keeps the unemployment rate stable. At 4.3 per cent, the unemployment rate in the US is still a long way from recessionary territory, however.
For this reason, Powell said the rate cut was “risk management” – pre-empting a recession rather than reacting to one.
Inflation has been rising at the same time as unemployment, with the personal consumption expenditure index running at about a 2.9 per cent annual rate – well above the Fed’s 2 per cent target.
“Ordinarily, when the labour market is weak, inflation is low, and when the labour market is strong, that’s when inflation is a problem,” said Powell. “Now you have a situation where we have two-sided risk, and that means there’s no risk-free path.”
For that reason, the range of rate predictions was all over the map, with some of the Fed’s voting members predicting two bumper cuts this year, and some predicting no more cuts at all.
When the Fed’s decision was made, the Russell 2000 index of small caps – the most closely tied to the fortunes of the US economy – surged by more than 2 per cent, setting its first new record highs since before the pandemic.
Those gains faded during the press conference, however, as Powell offered caveats to the new policy position. He reminded markets that the rate-cut plans were subject to change.
Decisions were being made “meeting by meeting”, and the Fed would continue to take cues from economic data. In other words, all it would take to cancel the rate cut promised for October would be one hot inflation report.
So far, Powell said, most US importers – rather than the exporters selling the goods – have borne the bulk of the increased costs associated with tariffs.
Those importers intend to pass on those costs to customers eventually, he said, which would likely drive up product inflation further. Still, the central bank’s assumption remains that tariff inflation will be a short-lived, one-off event.
Responding to questions about whether Trump’s effort to fire board member Lisa Cook or to allow new member Miran to keep his White House job compromised the Fed’s independence, Powell had a clear message: It was business as usual at the Fed.
Counterintuitively, the US dollar and Treasury yields rose in the wake of the move. Markets had priced in a rate cut after the August jobs report showed a meagre 22,000 added jobs. The volatile response could foreshadow nerves about the Fed making a mistake, and pouring fuel on the inflation fire with the cuts.
Many economists believe Powell’s action makes sense, however.
“Inflation will likely remain a two-part story of a growing tariff bump alongside a falling underlying trend,” said economists at Goldman Sachs Group.
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