What needs to happen for the Fed to stop raising rates?

As I had discussed in my previous columns, there are numerous indications that inflation is on the way down.

Unfortunately, the Fed doesn’t seem to be convinced, which is the reason why the stock market fell sharply last week. The recently released August jobs report showed that nonfarm payrolls increased by a larger than expected 315,000, while August inflation fell by a slower than expected pace to 8.3 percent. Because of this, the market now believes that the Fed is guaranteed to raise rates by 75 basis points during the FOMC meeting scheduled for this week, and potentially by a more aggressive 100 basis points.

Even though the jobs number seem to indicate that the US economy is doing well, there are also indicators showing otherwise. For example, the number of full-time jobs fell for the third month in a row in August, while the average weekly hours worked continued to drop. The number of job openings are also falling while job cut announcements are increasing.

Moreover, even though August inflation was higher than expected, it was down for the second month in a row from 9.1 percent in June and 8.5 percent in July. On a month-on-month basis, inflation increased by 0.1 percent, which is much lower than the 0.7 percent average since 2021.

Inflation expectations are also going down. According to the University of Michigan inflation expectation survey, the one-year inflation expectation dropped to 4.6 percent, while the five-year inflation outlook fell to 2.8 percent. The one-year number is the lowest since September last year, while the five-year number slipped below the 2.9-3.1 percent range for the first time since July 2021.

Sadly, the Fed is not leaving any room for errors. After all, it took a while for it to change its view that inflation was only transitory, and this might have been partly responsible for inflation hitting 40-year highs earlier this year. Moreover, in 1980, then Fed Chair Paul Volcker prematurely stopped raising rates and even cut rates because the US economy fell into a recession. However, inflation remained elevated, which prompted the Fed to tighten even more aggressively. This in turn led to another recession, with US gross domestic product falling by a steeper 1.8 percent in 1982 from 0.3 percent in 1980. Failure to permanently bring down inflation would have more disastrous consequences. Consequently, the Fed considers a higher jobless rate and slower economic growth as lesser evils.

For the Fed to be convinced that it has successfully beat inflation, the jobs number might have to weaken significantly. It might also want to see headline inflation not just trending lower but falling closer to the 2.0 percent level. However, once economic indicators prove beyond a doubt that inflation is no longer a problem, the US economy would most likely be headed to a hard landing. After all, it takes time for changes in monetary policy to have an impact on the economy, putting the Fed at risk of over tightening. The Fed’s relentless battle against inflation would also hurt other economies around the world, including the Philippines, since central banks would have no choice but to raise interest rates to address the diminishing interest rate differential with the United Staes and prevent their currencies from depreciating sharply. INQ