The Fed Faces a Critical Decision as Inflation Eases

Easing Inflation, but Uncertainty Remains

Recent inflation reports have shown significant progress in curbing price pressures. One key measure, the consumer price index (CPI), now shows 12-month inflation at its lowest since February 2021. Wholesale price data also suggests that inflationary pressures in supply chains are largely under control.

These signs of cooling inflation have fueled expectations of a rate cut at the Federal Open Market Committee (FOMC) meeting, which concludes Wednesday. Economists and markets had initially anticipated a 25 basis point cut, but recent data has left the door open for a more aggressive 50 basis point reduction.

The Case for a Bigger Cut

Claudia Sahm, chief economist at New Century Advisors, is among those calling for a larger cut. "We’ve had two more months of good inflation data since the last Fed meeting,” Sahm said in a CNBC interview. "The federal funds rate has been over 5%, and it’s been there for over a year to fight inflation. That fight is won. They need to start getting out of the way."

Sahm argues that a 50 basis point cut would help stabilize a labor market that has shown signs of weakening. "The labor market has gotten weaker since last July," she said, adding that a larger cut would signal a recalibration of Fed policy and prevent further job losses.

Inflation Progress, but Challenges Remain

While inflation has cooled, it has not yet reached the Fed’s target of 2%. The CPI rose just 0.2% in August, bringing the full-year inflation rate to 2.5%. However, core inflation, which excludes volatile food and energy prices, remains higher at 3.2%.

Much of the core inflation pressure comes from high shelter costs, driven by the Bureau of Labor Statistics "owners equivalent rent" metric. This measure, which estimates the rental value of owned homes, accounts for 27% of the total CPI and has risen 5.4% over the past year.

Despite these lingering pressures, consumer confidence in inflation control is growing. A recent University of Michigan survey showed that Americans expect inflation to average 2.7% over the next 12 months, the lowest figure since December 2020.

Employment Concerns Loom

While inflation is trending downward, concerns about the labor market remain. Fed Chair Jerome Powell has expressed that the central bank does not seek further weakening in labor conditions. Powell’s goal is to maintain stable prices without sacrificing job growth.

"If Powell wants to deliver on his promise of no further labor market cooling, they need to act quickly," Sahm said. "The cooling trend is well established, and unless interrupted, we will continue to see payrolls decrease and unemployment rise."

The Case for a Quarter-Point Cut

However, not all economists are in favor of a larger rate cut. Some argue that a more measured approach is necessary, with a quarter-point reduction being the safer move. Tom Simons, U.S. economist at Jefferies, believes the Fed is focused on normalizing policy without overreacting to current conditions.

“They are normalizing policy and not trying to provide accommodation for an economy that is in trouble,” Simons said. He predicts the Fed will opt for a 25 basis point cut but believes there will be room for further reductions later in the year.

What’s Next for the Fed?

Market pricing suggests that rates could drop by as much as 1.25 percentage points by the end of 2024. This would bring down borrowing costs from their current range of 5.25% to 5.50%, their highest level in 23 years. While inflation has shown signs of stabilization, the Fed must be cautious about potential changes in economic dynamics.

"The Fed has been cautious about cutting rates because of concerns that inflation might return," Simons said. "Now, they have more confidence, but they still need to monitor the situation closely."

With the Fed set to make its next move, all eyes will be on Wednesday’s announcement to see how policymakers balance the dual mandates of controlling inflation and supporting the labor market. The outcome will have significant implications for the broader economy and financial markets.