The Fed’s great balancing act
By Peter Garnry, Chief Investment Strategist at Saxo
While the market is betting on significant Fed rate cuts, the latest inflation report and other economic indicators do not warrant an immediate need for aggressive action by the Fed.
The US inflation report for August was published on Wednesday and is the last comprehensive macro figure before the Fed decides on its policy on Wednesday. While consensus among economists is a 25 bps cut, the market has a 55% probability for a 25 bps cut and 45% probability for a 50 bps cut. As the market has not fully priced in a 50 bps cut, it would be unusual for the Fed to go with 50 bps as it would be interpreted as a hawkish move and something that could upset markets a lot. The market wants the Fed to be aggressive on its policy rate pricing in 6 rate cuts by the January 2025 meeting indicating that at least two of the next four meetings will include a 50 bps cut.
We think the market is too aggressive and too pessimistic on its outlook for the economy and inflation, just it was earlier this year. Let us look at the facts. The US inflation report for August showed that the US services inflation excluding energy is maybe stabilising around the 4% level, which means we only need a little positive impulse from either energy, food or manufacturing (China) for inflation to suddenly appearing worse again. US Indeed job postings data has also stabilised over the past three months suggesting that the labour market has cooled to a new equilibrium, but not necessarily an equilibrium that puts the economy into a recession. US financial conditions have also eased substantially in recent weekly data points suggesting no signs from credit markets that the economy is deteriorating fast. Finally, the Dallas Fed Weekly Economic Index is indicating 2% annualised real GDP growth and has remained surprisingly stable around the 2% level for two months now.
It is a great balancing act for the Fed, but we do not think the numbers are stacking up yet for the Fed to pre-emptively being aggressive on the policy rate. In his 2018 Jackson Hole speech, Federal Reserve Chair Jerome Powell highlighted the importance of being cautious when the economic outlook is uncertain. He emphasized that monetary policy decisions should be based on careful consideration of evolving economic conditions, rather than rigid adherence to models. Powell also noted that economic changes, such as shifts in inflation and unemployment, are difficult to detect in real-time, further complicating policy decisions. This uncertainty calls for a balanced approach, avoiding both extremes of excessive caution or aggressive tightening. In other words, the Fed will move cautiously on its policy rate as long as we are getting inflation reports like the one for August.
