The Fed’s September dilemma

The Federal Reserve's upcoming FOMC meeting is highly contentious, with market expectations for a 25 basis point rate cut contrasting with significant internal divisions. While slowing job growth, averaging just 35,000 monthly since May, supports a cut, the primary concern for holding rates steady is the elevated risk of de-anchoring inflation expectations. Despite tariffs being a one-time price shock, the article highlights that with 5-year inflation expectations already at 4% (University of Michigan survey), a rate cut could entrench higher inflation, potentially forcing the Fed into future rate hikes and increasing recession risk.

Analysis

The upcoming Federal Open Market Committee (FOMC) meeting is framed by a significant conflict between weakening economic growth and the rising risk of unanchored inflation expectations. The case for a 25 basis point rate cut is supported by a sharp deceleration in job creation, which has fallen to an average of just 35,000 per month since May, and the fact that the current federal funds rate of 4.25%-4.50% is perceived by most FOMC members to be restrictive relative to the estimated 3% neutral rate. However, the counterargument for holding rates steady is compelling and centers on inflation risks. Core CPI remains elevated at approximately 3%, and expected tariff hikes are poised to exert further upward pressure on prices. The primary concern, underscored by recent research cited in the article, is that another inflationary shock so soon after the 2021-22 surge could destabilize long-term inflation expectations. This risk is substantiated by the University of Michigan survey, which shows 5-year inflation expectations have jumped to 4%, a level surpassing the peak during the COVID-19 inflation surge. This indicates a potential policy dilemma where a pre-emptive rate cut to address slowing growth could inadvertently entrench inflation, forcing more aggressive and recession-inducing rate hikes in the future.

Key Decisions for Investors

• Given the deep division within the FOMC and conflicting economic signals, investors should anticipate heightened market volatility around the policy decision and avoid over-leveraging positions based on the market's expectation of a guaranteed rate cut.
• Pay close attention to forward-looking inflation expectation surveys, such as the University of Michigan data, as these are being framed as a more critical leading indicator for the Fed's reaction function than slowing payroll figures.
• Re-assess exposure to long-duration assets, as the risk of the Fed holding rates steady to combat inflation expectations is significant, potentially leading to an underperformance of rate-sensitive bonds and growth equities.
• Factor in the heightened political pressure on the Fed as a non-trivial variable that could influence the outcome, adding a layer of unpredictability beyond purely economic data.