July 25, 2024

Fed’s Delayed Rate Cut Could Trigger Economic Turbulence

The Federal Reserve’s projection of just one interest rate cut for the year has raised concerns among economists, who fear the move may come too late to effectively address emerging economic issues.

Recent data indicates a cooling in consumer spending, with May’s retail sales showing a slower pace compared to last year. This has alleviated some concerns about an overheated economy amid the fight against inflation. However, the labor market presents mixed signals: while job growth exceeded expectations, the unemployment rate rose to 4%, the highest since January 2022. Citi’s Economic Surprise Index, which tracks the extent to which economic data outperforms forecasts, is near its lowest level in over a year.

Inflation data for May offers a more optimistic view. The Consumer Price Index (CPI) increased at its slowest rate since July 2022. Coupled with a favorable reading on wholesale prices, economists expect the Fed’s preferred inflation measure, the Personal Consumption Expenditures (PCE) index, to have risen at its slowest pace this year in May.

With inflation easing and economic growth slowing, Neil Dutta of Renaissance Macro suggests the Fed should expedite interest rate cuts to support its dual mandate of price stability and maximum employment. Dutta argues that the core inflation momentum is likely to soften further, making the trade-offs with the labor market more challenging for the Fed.

Dutta’s concerns are echoed by Federal Reserve Chair Jerome Powell, who acknowledges a gradual cooling in the labor market, which he describes as moving towards a better balance. However, Dutta and Goldman Sachs’ economics team are wary of where the data might head next. They note that job openings have returned to pre-pandemic levels, and any further decline could lead to higher unemployment, following the Beveridge curve trend.

The Federal Reserve’s research indicates that further movement along the Beveridge curve could reduce the chances of a soft landing and increase the risk of recession. Dutta believes the Fed is aware of this risk and is cautious about pushing labor demand to weaken further.

While some economists are more concerned about potential future spirals in economic data rather than current trends, Deutsche Bank’s chief US economist, Matthew Luzzetti, suggests that the labor market risks are present but not yet alarming. He notes that the slowing consumer spending power appears to be normalizing rather than dropping off significantly.

From an investment perspective, the Fed’s outlook has been well-received, with the S&P 500 (^GSPC) and Nasdaq Composite (^IXIC) hitting record highs. Three equity strategists have recently increased their year-end targets for the S&P 500, driven by strong performance in the tech sector. However, Citi’s US equity strategist Scott Chronert cautions that the economy’s “fraying” edges will remain a focal point for investors, especially as the effects of previous Fed rate hikes begin to weigh on economic activity.

Some experts worry that the Fed’s cautious approach to inflation might lead to delays in cutting rates, potentially harming the economy. With dwindling excess savings and rising credit card delinquencies, Allianz’s chief economic adviser Mohamed El-Erian warns that small businesses and lower-income households are already struggling with higher rates. El-Erian believes the Fed risks waiting too long to cut rates, which could result in an unnecessarily sharp economic slowdown.

Key Takeaways:

  1. The Federal Reserve’s projected single interest rate cut for the year may be insufficient and delayed.
  2. Consumer spending is slowing, and the unemployment rate has risen to 4%.
  3. Inflation data for May is more promising, with the CPI increasing at its slowest pace since July 2022.
  4. Economists suggest the Fed should cut rates sooner to support maximum employment.
  5. There are concerns about potential economic spirals if the Fed delays rate cuts.
  6. The stock market remains optimistic, with strong performance in the tech sector.
  7. Some experts fear that waiting too long to cut rates could harm the economy, especially for vulnerable groups.

Conclusion: As the Federal Reserve navigates its dual mandate, balancing inflation control with maximum employment, the timing of interest rate cuts will be critical. While recent data shows a cooling economy and easing inflation, the labor market’s mixed signals highlight the complexity of the Fed’s task. Investors remain cautiously optimistic, but the potential risks of delayed action could have significant implications, particularly for small businesses and lower-income households.

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