S&P Global Ratings now believes that the rate-cutting cycle in the U.S. will begin with a 25-basis-point cut at the Federal Open Market Committee's next meeting, in September (instead of a first cut in December, as we had previously forecast). The Federal Reserve has yet to explicitly signal the timing of its future actions, but so far, progress against inflation and the normalization of the labor market are likely enough for the central bank to start dialing back its tight stance on monetary policy.

We think the recent loosening of the labor market indicates a normalization, as opposed to a U.S. economy that's about to slip into recession. An expansion of the labor force, rather than a fall in employment, has spurred the rise in the unemployment rate up to now--a key difference from previous cycles at the start of a recession. Other data paints a picture of a labor market that's cooling, but not collapsing.

The downshift in economic growth during the first half of this year (as we had expected) reflects a controlled deceleration toward a longer-run steady state, which is exactly what the Fed hoped for and is consistent with a normalization process. Growth in inflation-adjusted final sales to private domestic purchasers--consumer spending plus business fixed investment, a good indicator of underlying demand--moderated to 2.6% (annualized) in the first half from 3.2% in the second half of 2023. It's a far cry from the kind of figures that would be consistent with a narrative that says that the bottom is falling out of the economy.

Moreover, in the second-quarter corporate results that have been announced so far, it's difficult to find any harbingers of broad-based deterioration (see "Corporate Results Roundup Q2 2024," published Aug. 5, 2024).

It's also the case that, at this point in the business cycle, pandemic-related dislocations are farther back in the rearview mirror. Indeed, inflation has come down without much collateral damage to the labor market. That said, there are signs of vulnerability in private demand amid the Fed's efforts to stamp out the last bit of excess inflation without letting employment weaken too much.

Because of all this, it's just about time for the Fed to recalibrate policy rates and get ahead of the curve.

In the coming year, we believe the Fed will carry out what will likely be a gradual easing of monetary policy as it sees the economy slow from above potential. Our baseline outlook envisions a steady, spaced-out series of rate cuts that will help the Fed engineer a soft landing--where demand stays close to potential while the last bit of excess inflation evaporates (see "Economic Outlook U.S. Q3 2024: Milder Growth Ahead," published June 24, 2024). We think the federal funds rate will likely fall to 3.75%-4.00% by the end of 2025 from the current range of 5.25%-5.50%, with 50 basis points of cuts coming this year and another 100 basis points of cuts next year.

Our previous forecast saw only 25 basis points of rate cuts in 2024; adding an extra 25-basis-point cut this year should only have a marginal effect on the GDP forecast we published in June (see "Economic Outlook U.S. Q3 2024: Milder Growth Ahead"). Economic growth is tracking close to what we expected. Our next macroeconomic forecast update will come in late September, in keeping with the regular schedule for our quarterly macroeconomic forecast updates, in conjunction with S&P Global Ratings' Credit Conditions Committee meeting.

A Soft Landing Is Anything But Assured

Our baseline view of a soft landing is not without risks (see "Credit Conditions North America Q3 2024: A Brighter Outlook, Laden With Risks," published June 25, 2024). We continue to think the probability of a recession starting within the next 12 months remains elevated, at 25%-30% (see "U.S. Business Cycle Barometer: Recession Risk Remains Above Historical Norm," published June 18, 2024). That's twice the unconditional probability of recession (baseline comparison) since World War II.

Geopolitical risks to macroeconomic outcomes (including, more recently, the heightened tensions between Iran and Israel) remain elevated, although the impact so far has been contained. A potentially disruptive U.S. election outcome also looms. A disorderly reaction in the financial markets to actual and perceived risks--if it persists--would lead to a higher chance of a recession as companies respond to a sustained tightening of financial conditions by cutting back on investment and headcount.

There are also key questions regarding the volatility that jolted financial markets in early August: whether or not that volatility will feed off of itself (kicking off a vicious cycle that loops back into the real economy), and how the Federal Reserve might respond if it does. We don't offer an explanation in this report for the recent volatility, but it's clear, in our view, that Fed policymakers will have to walk a fine line: avoiding the perception that they're acting in panic, while at the same time avoiding the perception that they're acting with insufficient urgency.

The extent to which downside risks to the real economy materialize, along with whether the sharp sell-off in financial markets causes something to break, could determine whether the Fed would end up cutting rates more aggressively than we currently foresee in order to break a potential negative feedback loop into the real economy.

How We Interpret The Latest Signals From The Fed

We think there's the potential in late August, at the annual Jackson Hole symposium, for the Fed to offer more explicit forward guidance following last week's meeting by the Federal Open Market Committee (FOMC), the news conference from Federal Reserve Chair Jerome Powell, and the release of the July jobs report. All three of those events last week reinforced the idea that the first rate cut will come sooner rather than later.

There was no doubt heading into the July FOMC meeting that the next move in this monetary policy cycle would be a move down in rates--this had already been established coming out of the June meeting. The question surrounding the July meeting was not if, but when.

After the FOMC left its policy rate unchanged at 5.25%-5.50%, Powell delivered remarks that included some notable developments:

• The U.S. economy is no longer overheated, and the labor market balance resembles what it looked like in 2019 (that is, not inflationary); and
• It's now appropriate to weigh risks to the employment and inflation mandates equally (as the weighing of risks before that had focused more on inflation).

The FOMC's post-meeting statement and Powell's remarks suggested that the first rate cut will come soon, assuming that officials see more of the same inflation data that they have been seeing since April or a softer-than-expected labor market. In the immediate aftermath, we interpreted both as signaling that a September rate cut would be on the table, but not a slam dunk: One discouraging inflation report between the July meeting and the September meeting would give the Fed pause, while a weaker-than-expected employment picture would encourage a rate cut.

The July jobs report released two days after the end of the FOMC meeting, we think, increased the odds of a rate cut. The slowdown in payrolls and the sharper rise in the unemployment rate--neither of which we see as a recession signal, at least at this stage--clearly marked a further deceleration in employment demand, which had been gradually moderating since last year. By itself, this deceleration makes a September rate cut the most likely outcome. But because it also signaled the emergence of slack/excess supply, it should boost the FOMC's confidence that inflation can stay at its current, lower rate.

The Fed will have a clear sense of July inflation by the time economists convene in Jackson Hole. The Federal Reserve Bank of Cleveland's inflation "nowcast" suggests that July and August inflation is running in the 0.16%-0.22% range month over month (or in the 1.9%-2.6% range, annualized), as measured by the headline and core personal consumption expenditures price indices; policymakers are likely to accept that as consistent with the 2% target. This would complete a run of three months with inflation near or below the target, which would balance out the three months of upward surprises in the first quarter (see chart 1).

Chart 1

We believe the U.S. growth outlook continues to mostly track the summary of economic projections published after the June FOMC meeting, though the median for the unemployment rate will need to be raised at the September meeting. GDP growth remains consistent with the cautious tone of the July FOMC statement and Powell's news conference, despite the downside risk signaled by the July jobs data. The Fed now appears to have slightly overshot with its inflation forecasts from June, but markdowns in September will still leave its inflation forecasts above 2.5% year over year--above the 2% target--through 2024.

The Soft July Jobs Report Overstates The Moderating Trend

The market was quick to react to the July jobs report, with federal funds futures pricing in about 125 basis points of rate cuts this year, up from closer to 75 basis points of rate cuts that were priced in after the July FOMC meeting.

The July jobs report was soft, and the weakening was evident across most measures. But, like always, some perspective is needed.

Payroll job gains decelerated in July much more than we expected, with the three-month trend now below the near-term break-even employment level needed to hold the unemployment rate steady.  According to the establishment survey, the U.S. economy added 114,000 nonfarm jobs in July, well below the consensus expectation of 175,000. On a three-month average basis, which is our preferred measure given monthly volatility and revisions, the economy is adding more than 170,000 jobs per month--a respectable pace, but just below the near-term break-even pace that would keep the unemployment rate steady (see chart 2).

Chart 2

Because of a recent surge in immigration and its subsequent impact on the labor supply, the pace of job gains needed to hold the unemployment rate steady has increased to about 200,000 net new jobs per month, according to estimates from the Federal Reserve Bank of San Francisco.

Contributions to employment growth have increasingly come from a narrower base.  Private payrolls rose 97,000 in July, with most of the gains concentrated in health care and social assistance (64,000), construction (25,000), and leisure and hospitality (23,000). Government hiring slowed, but the sector still added 17,000 jobs last month. Over the last 12 months, almost three-fifths of the job gains were in the government sector, the education sector, and the health care and social assistance sector--three sectors that are typically acyclical (see chart 3).

There's a risk that employment growth in those sectors will slow to a more normal pace for the rest of this year. First, job growth in all three sectors is near the pre-pandemic trend, which suggests that there would be less of a growth impulse from "catching up to the trend." Second, last year's strength in state and local finances may have faded away amid slowing revenue growth, and those governments will be constrained by balanced-budget rules.

Chart 3

Chart 4

The breadth of private-sector hiring--as captured by the diffusion index, where 50% indicates an equal balance between industries with increasing and decreasing employment--narrowed to near 50% over the last three months. That's the lowest level it has been during the current expansionary cycle, and it's a feature of a late-cycle economy (see chart 4).

It's likely that Hurricane Beryl contributed to weakness in the July payrolls figure from the establishment survey, given the weather-related spike shown in the household survey (see chart 5).  The number of people who are unemployed rose by 352,000 in July, but about 70% of that was due to temporary layoffs, likely stemming from the retooling of auto production plants and Beryl's aftermath. A jump in initial jobless claims in Texas, where Beryl made landfall, seems to explain much of the recent increase in initial unemployment insurance claims nationally.

Chart 5

So far, the expansion of the labor force, rather than a drop in employment, has been causing the rise in the unemployment rate.  The unemployment rate, which comes from a separate household survey, rose by 0.2 percentage points in July to 4.3%, returning to what the Congressional Budget Office and many FOMC participants consider to be the longer-run steady-state unemployment rate.

The 0.2-percentage-point rise in the unemployment rate, which has now triggered the Sahm Rule, has many worried that the economy may be falling into a recession. According to this rule, whenever the three-month moving average of the unemployment rate (currently 4.1%) rises 0.5 percentage points off its prior 12-month low (currently 3.6%), the economy has fallen into a recession.

Chart 6

Chart 7

We think some perspective is needed. There have been unusual shifts in labor supply during this particular cycle because of immigration and the pandemic, and this has caused the rise in the unemployment rate to be overstated. This is very different from what we have seen in past cycles. Increased supply, or the rise in unemployment for the "right" reasons, suggests that the threshold for a recession could be higher in this cycle.

Many people gained employment in July (67,000), but a substantially larger number of people joined the labor force (420,000). The labor force participation rate edged higher by 0.1 percentage points, to 62.7%. We like to look at workers between the ages of 25 and 54, specifically--both men and women continue to join the labor force, helping to loosen the labor market.

Chart 8

The increase in the unemployment rate this year has almost entirely come from the surge in labor force entrants and temporary layoffs.  The number of people who lost their jobs for "permanent" reasons (as opposed to "temporary" reasons) has essentially been flat this year, accounting for very little of the rise in the unemployment rate--we think this is more representative of the underlying condition of the labor market. And there has been very little change in the number of people who aren't in the labor force currently but say they want a job.

Chart 9

This means that new entrants and re-entrants to the labor force accounted for almost the entire increase in the headline unemployment rate before July, while a spike in temporary layoffs largely accounted for the sharp rise in the unemployment rate during July itself.

Several other indicators are showing that the labor market has normalized to where it was in 2018-2019.  The ratio of job openings to the number of people who are unemployed, the quits rate, the job openings rate, and layoffs are signaling that labor demand has cooled slightly, to levels we were accustomed to before the pandemic. Unemployment insurance claims remain relatively low, though continued and initial claims combined have recently been drifting higher.

Up to now, normalization has occurred through a large decline in the job openings rate, instead of through layoffs.  We've moved down the steep post-pandemic Beveridge curve. It's not clear yet if we've reached an inflection point where a further loosening of the labor market would come through layoffs, not just through a decline in open positions.

Chart 10