The Fed Should Not Cut In September

Markets currently think there’s less than a 2 percent chance that the Federal Reserve will not lower its policy interest rate at its September meeting. But the case against the Fed cutting rates in September is straightforward. Three points:

1. The Fed should not cut rates until there is solid evidence that inflation is moving sustainably toward 2 percent, its target rate. Such evidence does not exist. The Fed will know the June and July inflation data when it meets in September. We don’t know those data today, but the best forecast for June inflation suggests that such evidence will not materialize by the September meeting.

2. The Fed takes into account the strength of the labor market in setting monetary policy, as well as consumer price inflation. But while the labor market is certainly weakening, it is not weak. Labor demand still outpaces labor supply. Unfilled job vacancies are still substantially above pre-pandemic levels. Wage inflation is still running faster than is consistent with the Fed’s target for consumer price inflation.

3. To be sure, the combination of cooling inflation and a softening job market does suggest that a less restrictive policy stance is advisable. But what matters for monetary policy are overall financial conditions, not merely the federal funds rate. I argue in my latest Project Syndicate column:

Since the Fed’s pivot in November, rising equity prices and falling long-term interest rates and credit spreads have eased financial conditions considerably. Much of the financial tightening caused by the relatively high Fed policy rate has been undone. Markets are doing the Fed’s job for it. Fed Chair Jerome Powell said as much in congressional testimony last week: “It feels like policy is restrictive, but not intensely restrictive.”

My conclusion:

It may not be time to cut, but the Fed should be prepared to do so — especially if the labor market takes a dramatic turn for the worse, or if the next two PCE readings show clear evidence that underlying inflation is moving sustainably toward the Fed’s target. But the risk that inflation gets stuck above 2.5% is too great for policymakers to lower rates now.

The Fed has entered the last mile of its fight against inflation. With its credibility at stake, it must not flinch before it reaches the finish line.