Is the Fed behind the curve?

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Amid an expected decline in inflation but an unwelcomed deterioration in the labor market, the Federal Reserve is all but certain to ease interest rates at next week’s policy-setting meeting. The central bank has been on the sidelines with the upper band of its fed funds rate at a two-decade high of 5.50% since July 2023. A cut would mark its first since the depths of the global pandemic in March 2020. We expect a quarter-point cut at coming Federal Open Market Committee (FOMC), two more in each of the last two meetings of the year and one per quarter in 2025, depending on the data. Collectively, that could take the fed funds rate down to about 3% over the next two years.     

Turning a battleship The U.S. economy is huge—with a GDP of $28.7 trillion in the second quarter—and complex. The rule of thumb is that it takes about 12-18 months for the effect of an interest-rate policy change to fully filter through the economy. It’s been more than 30 months since the first hike in this tightening cycle, which begs the question, has the Fed waited too long to cut? Is it behind the curve and must jump-start the process with a larger, half-point cut? Many investors and economists are making the case for that, though the consensus view remains for a quarter-point reduction.

Two arguments against 50 First, policymakers know full well that a supersized cut can spook the markets. Historically, investors have viewed large moves as a sign the Fed must know something they don’t, in particular that the economy is in worse shape than it is letting on. That might play havoc due to the second contrary point: The Fed typically prefers to avoid altering monetary policy between Labor Day and Election Day to avoid looking politically minded. While weakening data would give the Fed cover for making a larger reduction next week, it might opt for the smaller amount.

Labor market deterioration In its annual benchmark revision last month, the Labor Department revised its payroll count down in the period from April 2023 through March 2024 by 818,000 jobs (an average monthly overstatement of 68,000 jobs), the largest such revision since the Global Financial Crisis. That means that nonfarm payroll gains have averaged only 116,000 jobs the past three months, the slowest pace since early 2020. The ADP private payroll report in August and the Job Openings and Labor Turnover Survey (JOLTS) in July posted their weakest reading since January 2021. Challenger layoffs in August were triple the pace in July, the manufacturing sector has lost jobs in four of the past seven months, retailers have shed jobs in each of the past three months (during the important Back-to-School season), and temporary hires (an important leading employment indicator) have lost jobs in 18 of the past 19 months.

Return of the rules? The deterioration has drawn the Fed’s attention away from its previous focus on inflation, which appears to be grinding lower, if inconsistently (see below). That dilemma defines the Fed’s dual mandate of balancing full employment and moderate inflation, represented by the Phillips Curve. For much of the last two years, the relationship seems to have been broken. But the softening job market suggests it might be working again. It's a similar story for the so-called Sahm Rule. This indicator states that if the rate of unemployment rises at least a half percentage point on a rolling 3-month basis within a year, the economy typically slows into a recession. Some economists expected this to have already happened due to the Fed's aggressive hiking campaign, but it has not until very recently. In each of the last two months, the Sahm Rule has been triggered, as the unemployment rate has risen from 3.4% in April 2023, a 53-year low, to 4.2% in August 2024.

Inflation divergence The Fed has made solid progress reducing inflation over the past two years, but we’ve noticed some recent divergence. One the one hand, nominal CPI has plunged from a 41-year high of 9.1% in June 2022 to 2.5% in August 2024. On the other hand, core PPI has risen from 1.8% in December 2023 to 2.4% in August 2024. Moreover, core PCE inflation (the Fed’s preferred measure) has stalled at 2.6% in each of the past three months through July 2024—down from 5.6% in February 2022—but the Fed believes that it will increase to 2.8% by the end of this year, before returning to 2.0% by the end of 2026.

Moving on up The Commerce Department revised U.S. second quarter GDP growth from a gain of 2.8% to 3.0%, compared with 1.4% in the first quarter and 3.4% and 4.9% in last year’s fourth and third quarters, respectively. 

Reducing our GDP and core inflation forecasts The liquidity, equity and fixed-income investment professionals who comprise Federated Hermes’s macroeconomic policy committee met Wednesday to discuss slower economic growth, lower inflation and Fed policy.  

• We left our estimate for third quarter 2024 GDP growth at 1.8%. The Blue-Chip consensus increased its from 1.7% to 1.9% (within a range of 1.3% to 2.4%). The Atlanta Fed’s GDPNow's estimate has slipped from 2.9% in early August to 2.5%. We reduced our projection of fourth quarter 2024 growth from 1.7% to 1.5%. The Blue-Chip consensus reduced its from 1.6% to 1.5% (within a range of 0.8% to 2.2%).
• We raised our full-year 2024 GDP growth estimate from 2.4% to 2.6%. The Blue-Chip consensus raised its from 2.3% to 2.6% (within a range of 2.5% to 2.7%).
• We reduced our year-end 2024 forecast for core CPI inflation growth from 3.2% to 3.1% (it printed 3.2% in August 2024), while the Blue Chip reduced its from 3.1% to 3.0% (within a range of 2.8% to 3.1%). We also lowered our year-end 2024 estimate for core PCE inflation from 2.8% to 2.6% (it printed 2.6% in July 2024), while the Blue Chip left its estimate unchanged at 2.5% (within a range of 2.4% to 2.6%).
• We left unchanged our year-end 2025 forecast for core CPI at 2.7%, while the Blue Chip reduced its estimate from 2.4% to 2.2% (within a range of 1.9% to 2.6%). We also left unchanged our year-end 2025 estimate for core PCE at 2.3%, while the Blue-Chip consensus cut its from 2.2% to 2.1% (within a range of 1.9% to 2.3%).

We initiated our quarterly GDP growth calls for 2025:

• Our first-quarter estimate is 1.6%, compared with the Blue-Chip consensus estimate of 1.7% (within a range of 0.9% to 2.3%).
• Second quarter 2025 is 1.8%, equaling the Blue-Chip's (within a range of 1.2% to 2.4%).
• Third quarter 2025 GDP is 1.9%, equaling the Blue-Chip's (within a range of 1.5% to 2.4%).
• Fourth quarter 2025 GDP is 2.0%, a tick below the Blue-Chip consensus estimate of 2.1% (within a range of 1.6% to 2.5%).
• These collectively lowered our full-year 2025 GDP growth estimate from 2.0% to 1.8%, while the Blue-Chip consensus left its unchanged at 1.8% (within a range of 1.3% to 2.3%). 

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