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At Wednesday’s much-anticipated policy-setting meeting, the Federal Reserve decided to cut interest rates for the first time in more than four years by a supersized 50 basis points, lowering the upper band of the fed funds rate to 5.0%. We here at Federated Hermes were expecting a more conservative quarter-point cut. But the Fed’s new Summary of Economic Projections (SEP) for September, which the central bank updates quarterly, articulated a welcomed decline in inflation but a worrisome deterioration in the labor market. Consequently, the Fed decided to front load the easing cycle, which it expects to run for the next two years. Chair Jerome Powell did his best to downplay the aggressive move, calling it a “recalibration” in his press conference following the Federal Open Market Committee meeting.

The Fed has been on the sidelines with the upper band of its fed funds rate at a two-decade high of 5.50% since July 2023, and this week’s cut marks its first interest-rate reduction since the depths of the global pandemic in March 2020. In its new SEP, policymakers expect to ease by an additional quarter point in each of the remaining two FOMC meetings (November 7 and December 18) this year, followed by four quarter-points cuts each quarter over the course of 2025 and two more in first half of 2026. If those come to pass, the terminal rate should approximate 3.0% two years from now.

Dual mandate Fed officials must artfully navigate the Phillips Curve tradeoff between moderate inflation and full employment. While they are delighted inflation is grinding lower, they are legitimately concerned about the deterioration in employment, particularly over the past few months. That precipitated, in our view, their more muscular half-point cut on Wednesday, as they hope to stick the proverbial soft landing rather than push the economy into recession. 

Inflation divergence? The Fed has generally made excellent progress reducing inflation over the past two years. Nominal CPI retail inflation has plunged from a 41-year high of 9.1% in June 2022 to 2.5% in August 2024. But core PPI wholesale inflation has risen from 1.8% in December 2023 to 2.4% in August 2024. Moreover, core PCE inflation (the Fed’s preferred measure) has stalled at 2.6% in each of the past three months through July 2024—down from 5.6% in February 2022—but it is expected to increase to 2.7% in August. The updated SEP estimates that core PCE will be 2.6% at the end of this year, on its way to its 2.0% target by the end of 2026.

Labor market softens The unemployment rate (U-3) has risen from a 53-year low of 3.4% in April 2023 to 4.2% in August 2024. The June SEP forecasts it would decline to 4.0% by year-end, but the September update expects a much higher 4.4%. The increase in U-3 triggered the Sahm Rule in July. It states that if U-3 rises a half percentage point or more on a rolling 3-month basis within a 12-month period, the economy typically enters into a recession. 

Broad-based weakness In its annual benchmark revision in August, the Labor Department revised the U.S. payroll count in the period from April 2023 through March 2024 down by 818,000 jobs. That is the largest such revision since the Global Financial Crisis in 2009 and means the Dept. overstated job gains by an average of 68,000 per month in the period. And it means that nonfarm payroll gains have averaged only 116,000 jobs the past three months, the slowest pace since early 2020. 

Moreover, the ADP private payroll report in August and the Job Openings and Labor Turnover Survey (JOLTS) in July posted their weakest readings since January 2021. Challenger layoffs in August were triple the pace in July, the manufacturing sector has lost jobs in four of the past seven months, retailers have shed jobs in each of the past three months (during the important Back-to-School season) and temporary hires (an important leading employment indicator) have shed jobs in 18 of the past 19 months. 

What about the election? The Fed prides itself on being apolitical. According to the Wall Street Journal, over the last eight presidential election cycles since 1990, the Fed has cut rates between Labor Day and Election Day only three times. Historically, officials have been prudent and judicious in changing policy during the final stages of presidential election to avoid even the appearance of impropriety. However, when they feel action is needed, they certainly have.

With inflation much lower today than its peak in 2022, Wednesday’s supersized cut is likely to draw the ire of Republicans. The GOP will contend the Fed is putting its thumb on the scale to benefit the White House’s incumbent party. Amid this year’s presidential election, we believe that weakening employment data certainly justifies the rate cut. But we would have liked to see a smaller amount, followed with additional action—if warranted—after the election. 

Does the Fed know something the markets don't? Many investors, like us, were expecting a slimmer quarter-point ease. Could the aggressive reduction frighten investors into thinking policymakers believe the economy is in bad shape? It doesn’t seem like it. The S&P 500 has soared 12% from its August 5 low to yesterday’s euphoric 39th record high this year at 5,733, as investors began to discount the pace of easing. But the estimated $250 in S&P 500 earnings this year equates to an elevated price/earnings ratio of 23. Benchmark 10-year Treasury yields are now at 3.72%, which translates into a target P/E of about 18 times in the so-called Fed model. That suggests stock investors are overly optimistic by about 25% or so. 

While stocks typically rise when the Fed is hiking interest rates and shifts to a pause, they tend to correct when rates begin to decline. That’s because an easing cycle signals the Fed thinks the economy is slowing, with a deteriorating labor market, and declining corporate earnings. As a result, we remain cautious on stocks for the near term, given the potential for a temporary 8-12% correction in coming months. 

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