A Careful Recalibration Needed

This week’s data reflects the resilience of the U.S. economy. Currently, the economy is holding steady with jobless claims in the 230,000 range and recent inflation data showing stability. Friday’s inflation report was essentially at expectations and indicates that the Federal Reserve (Fed) will make a rate cut of at least 25 basis points (bps) at the September meeting. Whether the cut is 25 or 50 will depend mostly on this week’s employment report.

I continue to advocate for the Fed to accelerate its rate reduction to get to a neutral policy rate to stave off potential recession risks. I believe that the neutral rate is between 3% and 4% for the Fed Funds Rate. Importantly, there are no significant inflationary pressures across commodities and foreign exchange markets, indicating that the economy can absorb such a policy shift without igniting inflation.

The recent GDP estimate by the Federal Reserve Bank of Atlanta has been adjusted up to 2.5% based on personal income and spending data. However, the data for this quarter is scarce; and the final growth rate could dip; I doubt it will reach the 3% GDP growth rate for Q2.

In the markets, technology stocks have shown some softness since the mid-July high, yet I don’t think we can call this a significant shift away from tech to other sectors yet. Real movement is likely once the Fed begins lowering rates, which could shift investor confidence towards smaller firms disproportionately affected by higher rates.

Looking ahead to the Fed meeting on September 17th and 18th, I expect an upward adjustment in the long-term Fed Funds target rate (the neutral rate, R*)—which the Fed currently shows at 2.8% but I believe is closer to 3.5%. I believe that the discussion of this meeting will be about R* now that the rate cutting phase has begun.

Right now, the Fed Funds Futures market is indicating a 4.31% rate for December, 100 bps lower than the current rate. Recall, the Fed Funds Future market is not an unbiased predictor of the funds; because of risk premiums, the market rate is downward biased. With election and geopolitical uncertainty, it thinks the funds market is predicting three 25-bps rate cuts. For the June 2025 meeting, the Fed Funds Rate is predicting a further three 25-bp cuts, if we take out the risk premium. We will then be much closer to the new neutral Fed Funds Rate of 3.5%; but well above the Fed projection of 2.8% given at its June meetings.

In essence, while the U.S. economy shows signs of cooling, it is not heading towards a dramatic downturn. Instead, a careful recalibration of interest rates by the Fed could help sustain growth and alleviate potential pressures, making the next few months critical for policy direction, economic stability and the market’s behavior.