The Federal Reserve is preparing to begin easing its tightening policy this month due to cooling inflation and a slowdown in the labor market. One major question policymakers are facing now is whether a 25 basis point rate cut will be enough to keep the economy in an expansionary mode.

The non-farm payrolls report released last Friday showed that hiring in the United States has slowed down over the past three months, reaching the lowest level since the outbreak of the pandemic in 2020. Despite this, these numbers still leave investors skeptical about whether Federal Reserve officials will choose a significant rate cut at the meeting on September 17-18.

This report sets the stage for an intense debate within the Federal Reserve, with officials like Fed Chair Powell possibly inclined to a significant rate cut to ensure the Fed does not lag behind the situation, while others are still hesitant about whether to cut rates by 25 basis points, according to Diane Swonk, chief economist at Grant Thornton.

Under Powell's leadership, the Federal Reserve made the mistake of acting too slowly, which led to the worst inflation wave since the early 1980s not being properly controlled, weakening the purchasing power of American households. If they act too slowly this time, they could cause an increase in unemployment and push the economy into a recession.

Swonk said, "Powell must now think about his political legacy. He must truly achieve a soft landing."

Federal Reserve officials are facing the choice between gradual easing or a significant rate cut, which is bound to be controversial and often happens during major shifts in monetary policy.

With most economic indicators now showing a downward trend, some economists believe that taking cautious measures poses greater risks than taking proactive action. As consumer spending decreases, an increase in unemployment can quickly become self-reinforcing, leading to more layoffs in companies. The unemployment rate has already risen by almost one percentage point from its low point last year, triggering a recession indicator called the 'Sam Rule'.

"This has raised some serious questions, not only about this meeting, but also for the next few months," Chicago Fed President Gülşen last Friday. "How do we work hard to prevent the situation from getting worse?"

Another report released by the US Bureau of Labor Statistics on September 4th showed that job vacancies in July fell to the lowest level since the beginning of 2021. The ratio of job vacancies to unemployed persons, which peaked at 2:1 during the labor shortage at the peak of the epidemic, has now fallen to about 1:1.

Both reports followed Powell's remarks on August 23, when he said at the Jackson Hole, Wyoming meeting that he and his colleagues "are not seeking nor welcoming further cooling of the labor market conditions."

"Powell is trying to pull the Fed in a dovish direction," said Tim Duy, chief US economist at SGH Macro Advisors. "If the economy unexpectedly slows and rates are too high, the economy will not be able to adapt to this situation."

Last Friday, the initial employment report led investors to increase their bets on a 50 basis point rate cut by the Federal Reserve, causing significant market volatility. A few hours later, Fed Governor Woller hinted that the possibility of a 50 basis point rate cut is unlikely until more data is released in the coming months, and these bets were reduced.

The US government will release two additional non-farm employment reports between the Federal Reserve's September policy meeting and the next meeting on November 6th and 7th. Investors are currently optimistic about the possibility of a 50 basis point rate cut at the November and December meetings.

"The Fed tends to take a gradual approach," said Stephen Juneau, economist at Bank of America. "If economic activity remains strong, they don't want to send the wrong signal to the market. Overall, the US economy still seems to be performing well."

If the Fed cuts rates by 25 basis points this month, and by 50 basis points in November and December, this will lower the target range for the federal funds rate to 4% to 4.25%, but this level is still far above the "neutral" level that most Fed officials believe is putting pressure on economic activity.

Inflation risk.

In recent weeks, some Federal Reserve officials have expressed concerns that if the Fed cuts interest rates too quickly and stimulates economic activity, inflation could face upward risks. The Fed's preferred inflation indicator, the Core PCE Price Index, is still at 2.5%, slightly higher than its 2% target.

These policymakers can also point out the trend of layoffs, despite the slowdown in hiring, the layoff rate remains low.

"History tells us that premature monetary policy easing is a dangerous gamble that could reignite inflation and persist in the economy for months or even years," Atlanta Fed President Bostic wrote in an article on September 4th.

For Powell, the risk of a slowdown in the labor market undermines the extraordinary achievement the Fed has achieved so far - a soft landing. In 2022 and 2023, the Fed launched the most aggressive tightening cycle in 40 years to curb inflation. Achieving inflation at a reasonable level without triggering a recession would be a rare achievement.

And achieving this goal may depend on future rounds of interest rate decisions. Neil Dutta, Chief Economist at Renaissance Macro Research, said,

"The Fed should act when the increase in the unemployment rate is relatively moderate, rather than waiting until it becomes so obvious that it is already too late."

Editor/Somer