With inflation gradually cooling and the labor market rapidly cooling, the Fed's interest rate decision this week is more complex than ever before.

Currently, the market still has various predictions for the extent of the Fed's interest rate cut. Last week, 'New Fed Newsletter' Nick Timiraos published an article, suggesting that a 25 basis point and a 50 basis point interest rate cut is a 'close decision'. Matt Luzzetti of Deutsche Bank believes that the article tends to support a larger interest rate cut.

The Financial Times' Colby Smith also published a similar article, with Matt Luzzetti's interpretation being that the article tends to oppose a larger interest rate cut.

On the 15th, Greg Ip, a senior central bank reporter for The Wall Street Journal, analyzed the current economic situation and believed that the need for further interest rate cuts by the Fed is increasingly evident, advocating for a 50 basis point rate cut. CNBC reporter Carl Quintanilla commented, "The opinion leaders have spoken!"

Inflation has approached the Fed's 2% target.

Greg Ip believes that the current economic environment has changed significantly, and the 'inflation victory' has become a foregone conclusion, providing sufficient reason to support a substantial interest rate cut by the Fed.

According to the latest data, some core inflation indicators have fallen to below 3%, and even close to the Fed's 2% target. For example, the core inflation rate, which excludes food and energy price fluctuations, has dropped from 4.2% in August last year to 2.7%.

According to Jason Furman, an economist at Harvard University, a basic inflation rate equivalent to PCE is also showing that the current level of inflation is approaching 2.2%, the lowest point since the beginning of 2021.

Therefore, the continuous decline in the level of inflation has provided a more accommodative environment for the Federal Reserve to lower interest rates.

In addition, Greg Ip believes that changes in oil prices are also an important factor affecting inflation. In July, oil prices reached $83 per barrel, but have recently fallen below $70. The decrease in oil prices will not only directly lower the overall inflation rate, but also indirectly suppress the core inflation rate, as oil is a critical input in production and affects the costs of various industries.

According to a study by the University of California, Los Angeles, fluctuations in oil prices can explain 16% of the changes in core inflation, and their impact gradually manifests within two years.

Interest rates may revert to neutral.

Not only has current inflation slowed down, but market expectations for future inflation have also declined further. According to data from inflation-linked bonds and derivatives, the CPI is expected to rise by only 1.8% in the next 12 months, and the average inflation expectation for the next five years is 2.2%. This indicates that investors have confidence in the Federal Reserve's ability to achieve its 2% inflation target.

However, the decline in inflation expectations also means that real interest rates are rising. The current real short-term interest rates have reached 3.2% to 3.5%, while the Fed's officials believe that the "neutral" range for real interest rates is only 0.5% to 1.5%. Greg Ip believes that this indicates that the current level of interest rates has a significantly greater restraining effect on economic activity than necessary. Therefore, the Federal Reserve has even more reason to lower interest rates significantly.

In 2022, the Federal Reserve raised interest rates by half a basis point and three-quarters of a basis point because the real interest rate at that time was negative, far below the neutral level. Today, against the backdrop of easing inflation, the same logic should apply in reverse.

Cooling of the labor market

In addition, Greg Ip indicated that there are some signs of cooling in the labor market at present.

Data shows that in July of this year, the U.S. unemployment rate rose to 4.3%, which triggered market panic, as historically similar increases in the unemployment rate often signal an economic recession. By August, the unemployment rate had slightly declined to 4.2%. Other economic indicators such as consumer spending, unemployment insurance claims, etc., all show that the economy is still resilient.

Furthermore, the number of job vacancies per unemployed person has dropped from twice the level in early 2022 to the current level of 1.1 times, lower than the pre-pandemic level. Over the past three months, the average monthly job additions in the private sector was 0.096 million, also lower than the pre-pandemic level. This means that as job opportunities decrease, the pace of wage growth is likely to slow down, and the inflation threat remains small.

Fed's Dilemma: Which Risk Is Greater?

The Fed faces a dilemma at every interest rate decision: cutting rates too early may lead to an overheated economy, while maintaining high rates may exacerbate economic weakness. The question is, which choice poses the greater risk?

Greg Ip believes that a 50 basis point rate cut is not without risk.

Currently, long-term government bond yields have fallen below short-term interest rates, forming the so-called 'inverted yield curve', which could further decline, thereby lowering mortgage rates. Stocks may turn into bubbles. This will stimulate consumer spending.

However, if the interest rate is only cut by 25 basis points, the risk may be even greater.

The weakness of the global economy is already evident, and the default rates for car loans and credit cards are also rising. High interest rates are putting pressure on consumers. In fact, many analysts believe that the Federal Reserve should start cutting rates in July. If they only cut by 25 basis points this time, and more weak data comes out in the future, the Federal Reserve will be even further behind market expectations.

Will the Federal Reserve cut interest rates as expected by the market in this meeting? What impact will it have on the stock market? Welcome mooer to make an appointment to watch the September FOMC interest rate meeting~

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