Fears rise that Fed may mistime rate cuts as inflation inches lower

The US Federal Reserve is all but guaranteed to hold interest rates steady again this week. Yet with inflation moderating, joblessness on the rise, wage growth stalling and much of the domestic economy clearly slowing, there is a growing unease that the central bank may cut too late.

The rate-setting Federal Open Market Committee (FOMC) will surely debate the timing of rate cuts at its meeting this week, but when its meeting concludes July 31, Fed Chairman Jerome Powell will almost certainly announce that central bankers are again keeping the benchmark federal funds rate between 5.25% and 5.50%, where it has been for more than a year. The odds of the Fed cutting rates at this week's meeting were less than 5% as of July 26, about half of what they were a month ago, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.

While September now appears a more likely target for the Fed's first cut, some market watchers caution that waiting may pose economic risks.

"Inflation is within spitting distance of the Fed's target, the risks to the labor market are growing, and real interest rates are growing more restrictive even as the Fed holds," said Matthew Weller, global head of research with FOREX.com and City Index. "The Fed seems determined to run the unnecessary risk of waiting too long to start cutting interest rates, raising the likelihood that it will have to cut more aggressively to make up for lost ground later this year or in 2025 if the economy continues to slow."

The odds of at least one 25-basis-point rate cut at the FOMC's September meeting were 100% on July 26, while the chances of a larger 50-bps hike at that meeting at about 12%, according to the FedWatch Tool.

This week's meeting will offer "the clearest hint yet that officials are starting to seriously consider an interest rate cut, most probably at the subsequent September FOMC meeting," said James Knightley, chief international economist with ING.

"Inflation is looking better behaved, the unemployment rate is on the rise and there is growing evidence that consumer spending is cooling," Knightley said. "The Fed has been striving for a 'soft landing' and if the data allows them to cut, and it is certainly moving in that direction, then we think they will seize the opportunity."

The Fed has held rates steady as other central banks — including the European Central Bank, Bank of Canada and Sweden's Riksbank — have cut this year as demand for credit falls, said Samantha LaDuc, CEO and chief investment officer of LaDuc Trading.

"With the US 10-year [Treasury] yield 100 basis points below the federal funds rate, the Fed is behind the curve," LaDuc said. "I expect the narrative to switch from inflation to deflation into year-end."

In a July 24 column on Bloomberg, Bill Dudley, the former president of the Federal Reserve Bank of New York, wrote that with inflation pressures easing and the economy noticeably slowing, the Fed risks igniting a significant recession by not cutting rates now.

"Although it might already be too late to fend off a recession by cutting rates, dawdling now unnecessarily increases the risk," Dudley wrote.

The personal consumption expenditures (PCE) price index, the Fed's preferred inflation measure, increased 2.5% year over year in June, the lowest annual increase since February 2021, the Bureau of Economic Analysis reported July 26. The annual increase in core PCE, which strips out volatile food and energy prices, held at 2.6%, matching its lowest level since March 2021.

While inflation appears to be on the path toward the Fed's 2% target and some Fed officials will likely make the case for cutting rates now, Powell will stress that while inflation is sustainably moving downward, it is no longer the only risk the US economy faces, said Gregory Daco, chief economist at EY-Parthenon. As the labor market still struggles to balance, Powell will argue that any reduction in policy restraint needs to be timed correctly, Daco said.

"Powell will likely want to retain as much optionality as possible," Daco said. "He will likely emphasize that every meeting is 'live' and reiterate the now-familiar refrain stating that monetary policy remains dependent on the totality of data."

While some data backs the argument to cut now, there are not any "glaring signs" that one is needed immediately, said Oren Klachkin, a financial market economist with Nationwide. There could also be more risks of cutting too soon with the economy slowing, but at a manageable pace, and inflation still above the 2% target.

"I think it's best for them to wait given past false flags and the lackluster progress in taming inflation," Klachkin said. "They don't really need to rush this."