A September Fed cut is not a done deal

Tuesday’s rise in core CPI inflation was treated by the markets as confirmation that the Fed would cut rates in September. Which is surprising. Presumably it was because the number wasn’t worse and goods price inflation is still muted despite tariffs.

For the record, core CPI rose 3.0486% which, properly rounded, is 3%, though it was widely reported as 3.1%. But the fact is that US inflation is, at best, stable at 2.5-3% and quite possibly actually rising. This is due not only to goods inflation which is being lifted by tariffs, probably by 0.3-0.4% now. Services inflation is rising too. The Fed’s favourite sub-component, inflation in services ex shelter, has accelerated to 4% from 3.3% in April.

The case for a rate cut therefore depends mostly on activity data where there have been clear signs of a slowdown. In the GDP report, final sales to domestic private purchasers have averaged 1.5% this year compared with 3% in 2024. Measures such as retail sales and consumer spending have slowed too, while the savings rate has risen. Most strikingly, the July employment report reported a sharp decline in job gains in the last quarter and a tick up in unemployment to 4.2%.

This slowdown was widely expected when Trump’s policies created broad uncertainty early this year and, for a while, cratered the stock market. Tariffs were the main concern but there were also worries over reduced labour supply due to the immigration crackdown as well as lower spending when student loan repayments resumed. That said, some of the data suggests that the slowdown started before Trump’s inauguration which points to culprits such as high mortgage rates, slowing real wage growth and rising debt stress among lower-income households.

But the last three months have seen the stock market recover and the passage of the Big Beautiful Bill Act which made the 2017 individual tax cuts permanent and offers new ones too, as well as new cuts for businesses. Small business optimism jumped in July. Tariffs are still in play of course and, at the moment, the average tariff rate is about 18%, higher than most people expected. But business seems to be adapting.

President Trump has urged a massive cut in the Federal Funds rate while Treasury Secretary Bessent yesterday suggested a 50 basis point in September on the way to cutting rates by 1.5%. Pressure from the government as well as job-seeking by several FOMC voting members, hopeful of the Chairman’s job when Powell’s term ends next May, could nudge the decision towards easing.

However, the so-called Taylor rule, essentially a ‘rule-of-thumb’ for Fed decision-making suggests otherwise. It takes into account how far the twin targets of inflation and growth are from target and arithmetically derives an optimal Federal Funds. The original Taylor rule goes back to 1993 but various modified versions have been proposed over the years. So many in fact that the Atlanta Fed publishes no less than 30 different optimal rates, based on five models with differing parameters and assumptions.

Strikingly the range is from 4.04% to 6.08%, with an average of 4.95%, which compares with the current effective Federal Funds rate of 4.33%. A 25bps cut would take the effective rate to 4.08%. Only 3 of the 30 optimal rates would suggest that is the right move.

Probably the economy is indeed still slowing and a cut is warranted. Tariffs are so far showing up only a little in prices but that also means that they are not impacting much yet on consumer spending. However, it is possible also that confidence is reviving and that the economy will not look so weak in coming months, or at least not weaken further.

The next Fed meeting decision is on September 17^th. Before that we will have the Jackson Hole central bankers’ meeting (August 21^st -23^rd) which may or may not suggest a change in Fed thinking. More importantly we will have another month of data including the PCE inflation report, another CPI report, retail sales and personal income/expenditure, PMIs and the all-important August jobs report.

If the data generally stays soft and unemployment remains at 4.2% or drifts higher, a 25 bp cut is likely. If the data seem to soften even further then the market may start to anticipate a 50bp move. But if there are signs of firmness, such as payrolls over 100k or the unemployment rate falling again, the Fed may yet hold off.

We still expect a 25 bps rate cut because the slowdown will probably take at least a few more months to play out. But it is far from a done deal.