US rate cut: "The Fed believes that everything will continue to come together"

Eduardo García Castro, senior economist at MAPFRE Economics

At its last meeting and for the first time since September 2020, the US Federal Reserve decided to cut interest rates by 50 bps, leaving them in the 4.75%-5.00% range. The rate cut confirms the downward pivot the Fed already announced previously, specifically during the Jackson Hole symposium in August, and resolves the uncertainty about the size of the adjustment factor. The move was reinforced by a moderate message in which concerns about inflation were put to rest, optimism about growth was maintained, and the downward risk in employment was highlighted.

Along with the decision, an update of forecasts was presented with hardly any changes in GDP, unemployment that would go from 4.2% to 4.4% in 2025, and a more accomodating inflation path, with half a point less for the projected period and the objective being reached in 2026.

The members of the Committee made a practically unanimous decision in favor of the 50-bps cut. They also outlinined a future roadmap indicating an additional 50-bps cut for the rest of this year, 100 bps less for 2025 and 50 bps for 2026, with a long-term vision that once again sees rates remaining at between 2.75% and 3.00%, indicating that the neutral rate will probably be higher than in the past.

On the market side, the underlying probabilities derived from the swaps market have been dragged down by a certain erratic nature over the setting of the size of the movement; in fact, a relatively clear preference for 50 bps (range 60%-70%) did not appear until just a few days ago, signaled by the publication of several opinion articles in the press, specifically through the WSJ, FT and Bloomberg.

Furthermore, and unusually, economists disagreed on the pace of monetary flexibility (25bps consensus as per several surveys, including Bloomberg), as well as the political preference for a cut of 75bps. As such, and considering all the factors, it can be concluded that the decision was, at least, balanced.

Assessment

At first glance, it can be deduced that the labor market weakened over the summer, inflation continued to decline, and growth prospects remain good. These fundamentals support the shift toward a more balanced scenario in which a rate cut is justified. However, a second review of the data offers a somewhat more skeptical view of the deterioration in the data and in line with the dissent of recent weeks.

The premise for this vision has its roots in the thesis that inflation is moving sustainably toward 2%, as confirmed by the September data, which saw it scaled back from 2.9% to 2.5% year-on-year. When the components of inflation are analyzed, the dynamic continued to be driven downward by the prices of goods and energy, while services, specifically, housing, continue on the high side and would appear to put to rest any premature conclusions that the fight against inflation is over. In fact, during the press conference, questions about housing received relatively vague and inconclusive answers.

Little change has been evidenced on the pace of economic expansion, which remains solid and apparently does not offer any reason to condition the monetary policy decision, given that the latest GDP estimates for the third quarter are healthy, (see Graph 4). In fact, it may reinforce the perception that the objective remains to avoid any kind of slowdown.

Turning to employment, the main drivers of the change in position are the employment report (JOLTS) that suggests a deterioration in incoming data, an ex-post revision of the BLS (Bureau of Labor Statistics) data for the same period, and an unemployment rate that remains at the threshold of triggering the recession indicator known as the Sahm Rule. In detail, this first report can be interpreted from the viewpoint that the labor market is no longer overheated, in that the ratio between the workforce and vacancies has recovered its pre-pandemic balance.

As for the unemployment rate, it technically moved downward (from 4.3% to 4.2%), reinforcing the idea that, although fewer people are being hired, there are also fewer layoffs (weekly unemployment claims suggest a dynamic that is not very worrying). Finally, the Sahm rule is still within the trigger threshold - in fact, it fell below the recession trigger level (according to metrics and other refined proposals of the indicator, it could have a wider range), which is why there has been no movement on the part of the National Bureau of Economic Research (NBER), the official arbiter as far as declaring a recession is concerned. In short, a second reading that indicates that the weakening of the labor market may not be so serious.

Conclusion

The appropriate level of interest rates and the pace of adjustment will continue to be a volatile variable in the short term. This is evidenced by a somewhat bumpy communication process (involving simultaneous doses of optimism about the economy combined with warning signs to respond to the recent deterioration), and the contradictions that expose the difficulties facing the Fed in terms of providing clear forward guidance in a particularly difficult situation.

Added to all this is the proximity of November’s presidential election, a factor that warns of the possibility of labeling the Federal Reserve’s decision as “political.” However, the deeper interpretation invites us to think that the decision has been balanced and under the belief that in the future, the puzzle pieces will continue to fit together, which could lead to successive cuts in the dot plot coming to fruition. It is also to be expected that communication will be somewhat recalibrated to offer a little more visibility, at least once the elections are over, as a guarantee of independence and strict commitment to achieve monetary neutrality.