Is it finally time to cut?

July's consumer price index showed headline inflation at 2.9 per cent year-on-year, below three per cent for the first time since March 2021. Core prices rose by a modest 0.2 per cent on the month. The data no longer stand in the way of the Federal Reserve cutting rates.

From 9.1 per cent to here

The descent has been long. Headline inflation peaked at 9.1 per cent in June 2022, and the Fed answered with its fastest tightening campaign since the early 1980s, taking its policy rate from near zero in March 2022 to a range of 5.25 to 5.5 per cent by July 2023. It has held there for more than a year. A run of hot readings early in 2024 stalled progress and pushed expected cuts further out, and the spring and summer figures have since undone that scare.

Much of the improvement came from the goods side of the economy, where supply chains have healed and prices for items such as used cars and furniture have fallen back. Services have been stickier, because they depend more on wages and rents, both of which adjust slowly. The July figures showed services inflation easing as well, which is the progress officials had been waiting for.

Both sides of the mandate

Inflation is slowing comfortably and the jobs market is visibly softening, so the two halves of the Fed's mandate are back in balance. The central bank has stopped fighting a war on prices alone. Its main job now is to avoid causing a recession that nobody needs. Jerome Powell is clear to start easing.

The labour data make the point more forcefully than the price data. The July employment report, published on 2 August, showed payrolls rising by just 114,000 and the unemployment rate climbing to 4.3 per cent, its highest in almost three years. That was enough to trigger the Sahm rule, which flags a recession once the three-month average jobless rate rises half a percentage point above its low of the previous twelve months. The rule has a good record, though it was built for a labour force that was not being swelled by a surge of immigration.

Real rates are rising by default

With inflation falling and the policy rate unchanged, monetary policy has been tightening without anyone voting for it. Subtract 2.9 per cent inflation from a policy rate of 5.25 to 5.5 per cent and the real rate sits well above two per cent, the highest in well over a decade. Leaving it there is itself a decision to squeeze harder. The cost falls on floating-rate borrowers, on small companies that depend on bank credit and on households refinancing mortgages and car loans.

Who feels a cut first

The transmission is quickest where rates float. Banks set their prime lending rate at three percentage points above the top of the Fed's range, so it now stands at 8.5 per cent, and credit-card and home-equity rates are priced off it. Leveraged loans and much of the private-credit market reset every few months against short-term benchmarks, so a cut feeds through to corporate interest bills within a quarter. Mortgage rates move with longer-term Treasury yields rather than the Fed's rate, and they have already come down from above 7 per cent in the spring on the expectation of cuts.

The losers are easy to identify. Savers who have parked money in bank deposits and money-market funds yielding around 5 per cent will see those returns fall within weeks of each cut. Abroad, a less generous Fed tends to weaken the dollar, which eases the burden on emerging-market governments and companies that borrowed in dollars and gives their central banks more room to cut rates of their own.

The case for patience

The hawks still have arguments. Core inflation remains above three per cent on an annual basis, and shelter costs continue to supply most of the monthly increase. The economy grew at an annualised 2.8 per cent in the second quarter, hardly the profile of an economy in need of rescue. The 1970s showed how costly it can be to declare victory early: under Arthur Burns the Fed eased before inflation was beaten, and prices surged again.

Those arguments carry less weight than they did. Shelter inflation is a lagging measure, built on leases signed months or years ago, while market rents have been cooling for some time. A first cut from 5.5 per cent would still leave policy restrictive, merely less so. History also favours moving early: in 1995 Alan Greenspan's Fed cut after the tightening of 1994 and the expansion ran for the rest of the decade, while in 2007 it began easing only after credit markets had cracked and could not prevent a deep recession.

Monetary policy also works with long and variable lags, as economists since Milton Friedman have stressed. Rate cuts decided in September will take many months to reach hiring and investment decisions. Waiting until unemployment has risen further would mean the relief arrives after the damage is done, which is the pattern of past cycles in which the Fed moved too late.

What to watch before September

Mr Powell speaks at the Kansas City Fed's Jackson Hole symposium this week, a natural venue to signal a turn. The August payrolls report in early September and the August consumer price figures a few days later are the last big releases before the Federal Open Market Committee meets on 17 and 18 September. A payrolls gain well below 100,000 or another rise in unemployment would shift the debate from whether to cut by a quarter-point to whether half a point is needed. A sharp rebound in core inflation is the only thing that could plausibly keep the Fed on hold.

Futures markets already treat a September cut as close to certain, so the risk of surprising them lies in doing too little. Inflation under three per cent removes the last hawkish excuse for waiting. The Fed should start cutting at its next meeting, and very probably will, before a softening jobs market turns into a falling one. Expect at least a quarter-point cut on 18 September, with floating-rate borrowers feeling the relief by the end of the year and cash savers giving up part of their yield.