Cutting from strength, or from fear?

Headline consumer price inflation fell to 2.5 per cent in August, and the Federal Reserve is about to start cutting. The argument has moved on to motive. Jerome Powell may be easing because the economy is in decent shape, or because officials have begun to worry about what is coming.

How the ground shifted

The August figure was the lowest since early 2021, although core inflation, which strips out food and energy, rose 0.3 per cent on the month and remains above three per cent on the year. The labour market has done more to move the Fed than prices have. Unemployment has risen to 4.2 per cent, payroll growth has slowed and been revised down, and the Bureau of Labor Statistics has conceded that job growth in the year to March was overstated by 818,000. In June officials expected unemployment to end the year at 4.0 per cent, a forecast that is already stale.

The turn came quickly. In the spring, after inflation ran hot in the first quarter, officials were still debating whether to cut at all this year. Then the July jobs report showed unemployment jumping to 4.3 per cent, enough to trip the Sahm rule, an indicator with a good record of flagging recessions once they have begun. Markets lurched in early August as leveraged bets funded in cheap yen were unwound, and by the Jackson Hole symposium later that month Mr Powell was telling his audience that the time had come for policy to adjust.

The policy rate has sat at 5.25-5.50 per cent since July 2023, the highest in more than two decades. Because the nominal rate stayed put while inflation fell, the real rate has been rising. Each month of softer prices has tightened policy a little further without the committee lifting a finger, and that passive tightening is the strongest reason to move now, whatever the motive.

Insurance, or alarm?

The benign reading is the textbook one. Inflation is back near target and GDP is growing at two per cent, so the Fed can bring rates down before tight policy does needless harm to jobs. The less comfortable reading is that the committee sees a labour market close to the point where losses start to feed on themselves. If so, the cuts will come faster and go deeper than markets now expect.

The distinction matters because the two stories imply different destinations. An insurance cycle tends to stop once policy is roughly neutral, and the committee's own long-run projections put neutral a little under three per cent. An easing forced by a downturn usually carries the rate well below neutral, because the Fed is then trying to stimulate demand rather than merely stop restraining it.

Two kinds of easing cycle

The history comes in two flavours. In 1995, 1998 and 2019 the Fed cut a few times as insurance, the economy kept expanding and shares rose. In 2001 and 2007 it cut because the economy was already turning down, and the easing ran on for well over a year while recession arrived anyway. The first cut often looks the same in both cases, which is why the committee's forecasts matter so much.

The scale of the difference is large. Each of the insurance episodes amounted to three quarter-point cuts. In 2001 the Fed took its rate from 6.5 per cent to 1.75 per cent within the year, and between September 2007 and December 2008 it went from 5.25 per cent to effectively zero. Anyone pricing the current cycle is in effect choosing between a trim of less than a percentage point and a collapse of several.

Markets do not always tell the two apart at first. After the Fed's first cut in September 2007, the S&P 500 went on to a record high the following month before the financial crisis took hold. A rally after this week's decision would therefore say little about which kind of cycle has begun.

Where the tells will be

The clues will come on Wednesday afternoon. Futures markets have swung towards a half-point cut after a week of speculation, and a move of that size would be read as a sign of concern unless Mr Powell frames it carefully. The new projections matter more: a jump in the unemployment forecast or a median path showing steep cuts through next year would point to fear, while a modest path alongside steady growth forecasts would support the insurance story. His description of the labour market at the press conference will fill in the rest.

After Wednesday, the monthly payrolls report and weekly jobless claims become the main evidence. Claims have drifted up but remain low by historical standards, which argues against a labour market in free fall. A sustained rise in layoffs, as opposed to slower hiring, is what separates a cooling economy from a contracting one, and so far the slowdown has come mostly from firms hiring less.

Who gains from each version

The two readings favour different assets. Easing from strength tends to help cyclical shares, smaller companies that borrow at floating rates, and housing, where lower mortgage rates can revive sales. Easing from fear favours long-dated Treasuries and defensive sectors, and tends to widen credit spreads as investors price in defaults. Savers in money-market funds, which have drawn huge inflows at yields above five per cent, lose out under both.

The transmission is uneven. Floating-rate borrowers, from small firms on bank credit lines to households carrying credit-card balances, feel a cut within weeks because their rates reset off short-term benchmarks. American mortgages are mostly fixed for thirty years and priced off the ten-year Treasury yield, so homebuyers benefit only if long rates fall too. Much of that decline has already happened in anticipation, which limits how much further relief the housing market can expect from the cuts themselves.

The case for waiting

The strongest objection is that the Fed may not need to cut much at all. Core inflation above three per cent is not yet at target, shelter costs are still rising briskly, and an economy growing at two per cent with low layoffs does not look like one needing rescue. Easing too soon into sticky inflation is the error of the 1970s, when the Fed repeatedly let up before the job was done and had to tighten far harder later.

That argument has force, but it overlooks the level from which the Fed starts. Even after several cuts, the real policy rate would remain restrictive on most measures, so trimming it is closer to taking a foot off the brake than pressing the accelerator. The risk of a stubborn inflation rebound looks smaller than the risk of holding a restrictive rate while the labour market weakens.

On the evidence so far the insurance reading is the stronger one, though by a narrower margin than in the spring. The motive matters more than the first move. A Fed cutting from strength probably gives risk assets a gentle lift; a Fed cutting from fear will have investors repricing for recession within months.