The Fed's hawkish cut - no surprise

Markets reacted with surprise to Chair Powell’s emphatic remarks that another rate cut in December is not a done deal. They shouldn’t have been surprised if they were reading the Wall Street Journal or listening to Tricio podcasts! We have been among a number of economists arguing that the Fed is in danger of making a mistake by cutting too much. Clearly, some at the Fed think that too.

Three reasons for caution.

A. Growth is not that weak

The 3% GDP growth rate seen in prior years was made possible by rapid immigration. Net immigration has been cut to zero (possibly negative) which means that the ‘trend rate’ of growth is now 'only' about 2%. That’s pretty much where we were in the first three quarters of the year. We have the official data for H1 – which is 1.6% - but indications are that Q3 ran at 3% or more, which would give us 2% at least for January to September.

Going forward, ongoing concerns about tariffs do seem to be holding back non-AI investment. But AI investment looks set to stay strong for a while, judging by comments from the big tech companies. Another concern is that lower-income Americans are being stressed by higher prices, with wage growth and employment slowing. But more than half of Americans own stocks which are up big-time this year, while 70% own houses which have risen more than 50% since 2019. They are busy spending. Finally, there is concern that resumed student loan repayments are hitting many people.

On the positive side, people are getting used to a world with tariffs. And the One Big Beautiful Bill is stimulatory overall, only partially offset by tariffs. Perhaps growth will indeed slow further, but that is far from certain.

B. Core inflation is still at 3%

True, some indicators do suggest a downward bias – including wage growth and rents. But lower immigration and tariffs are inflationary, so there is a real risk that the Fed will struggle to get inflation below 2.5-3%. From there, inflation could easily go up again, if growth is too strong.

C. The neutral rate may not be much below 4%

Finally, the Fed (and Powell) are relying heavily on the view that the ‘neutral rate’ for the Federal Funds rate (the rate which is neither expansionary or contractionary) is close to 3%. So they can justify further cuts on the grounds that they are merely ‘reducing the restrictiveness of policy’. But where is the proof that rates are restrictive at current levels? Growth has stayed at trend or above. Sure, housing is under pressure but a booming stock market, low risk spreads and increasing financial market activity are not signs that monetary policy is restrictive. The ‘neutral rate’ could easily be 4%, especially given that actual inflation is near 3%.

Currently the market still expects a rate cut in December though the probability has dipped nearer 60% than the 90% seen before the October meeting. And markets also expect further rate cuts next year. Maybe. But if they don’t come, there could be some significant disappointment for both stocks and bond markets

Watch unemployment (when we get some numbers!)

The key will be unemployment. We won’t get a number in November. Hopefully the government restarts and the statisticians can produce a number for December. If unemployment starts to go down (from 4.3%) rate cuts would look dangerous. Only if it goes up, will the Fed have a strong justification for further rate cuts.