Jerome Powell hints at rate cuts as inflation eases but labor market challenges loom

With inflation falling toward its 2% target, hiring slowing, and unemployment rising, the Fed is poised to cut its benchmark interest rate from its 23-year high next month. But how quickly it cuts rates after that will depend largely on whether employers continue to hire. A lower Fed rate would ultimately lead to lower rates on auto loans, mortgages, and other forms of consumer credit.

Chair Jerome Powell is likely to offer some clues about how the Fed views the economy and what its next steps might be in a highly watched speech Friday in Jackson Hole, Wyoming, at the Fed's annual conference of central bankers. It's a platform Powell and his predecessors have often used to announce changes in their thinking or approach.

Powell will likely indicate that the Fed has increased confidence that inflation is heading back toward the 2 percent target, something the Fed has long said is necessary before starting to cut interest rates.

Economists generally agree that the Fed is getting closer to overcoming the high inflation that caused financial problems for millions of households three years ago as the economy recovered from the pandemic-induced recession. However, few economists believe Powell or any other Fed official is ready to declare that mission is “accomplished.”

“I don't think the Fed has anything to fear from inflation,” said Tom Porcelli, chief U.S. economist at PGIM Fixed Income. “At this point, it's right that the Fed is now focusing more on unemployment than inflation. Their policy is designed for inflation that is much higher than that.”

How quickly the Fed cuts rates in the coming months, however, will depend on what economic data shows. After the government announced this month that hiring in July was much lower than expected and the unemployment rate hit 4.3%, the highest in three years, stocks plunged for two days on fears that the U.S. could slide into recession. Some economists were already speculating that the Fed would cut rates by half a percentage point in September and perhaps another cut of the same amount in November.

But last week's better economic reports, including a further drop in inflation and a sharp rise in retail sales, have largely allayed those worries. Wall Street traders are now expecting three quarter-percentage-point Fed rate cuts in September, November and December, with December's rate cut almost a gamble on whether it will be a quarter-percentage-point or a half-percentage-point. Mortgage rates have already started to fall in anticipation of a rate cut.

A half-percentage-point Fed rate cut in September would be more likely if there were signs of a further decline in hiring, some Fed officials said. The next jobs report will be released on Sept. 6, after the Jackson Hole conference but before the next Fed meeting in mid-September.

Raphael Bostic, president of the Fed's Atlanta branch, said in an interview with the Associated Press on Monday that “signs of accelerating weakness in labor markets may justify a faster approach, either in terms of the gradual action or the speed with which we try to return to interest rates” that no longer constrain the economy.

Even if hiring remains stable, the Fed will cut interest rates this year as it continues to fight inflation, economists say. Last week, the government said consumer prices rose just 2.9 percent in July from a year earlier, the smallest increase in more than three years.

Bostic pointed out that the economy has changed from a few months ago, when he said a rate cut might not be necessary until the last three months of the year.

“I am more confident that we will achieve our inflation target,” he said. “And we have seen that labor markets have weakened significantly compared to last year.” “We may need to change our policy stance sooner than I previously thought.”

Both Bostic and Austan Goolsbee, president of the Fed's Chicago branch, say that when inflation falls, inflation-adjusted interest rates — which many companies and investors pay the most attention to — rise even though inflation has eased. When the Fed first set its benchmark interest rate at the current 5.3 percent, inflation — excluding volatile energy and food costs — was 4.7 percent. Now it's just 3.2 percent.

“In such situations, our measures become more stringent with each passing moment,” Bostic said. “We have to worry” that interest rates are so high that they could cause an economic downturn.

Still, Bostic said the labor market and economy appear largely healthy at present and he still expects a “soft landing” in which inflation returns to the Fed's 2 percent target without a recession.

With the economic outlook unclear and the Fed heavily focused on future data, Powell may not be able to say much about the central bank's next steps on Friday.

Given the Fed's focus on economic data, “it will be difficult for Powell to commit to a specific direction in advance at Jackson Hole,” said Matthew Luzzetti, Deutsche Bank's chief U.S. economist, in a research note.