Fed officials suffered a setback earlier this year as inflation remained stubbornly high. But new risks in the labor market have helped the central bank reshape the basis for rate cuts.

Nick Timiraos, a Wall Street Journal reporter who is known as the "Federal Reserve mouthpiece," said the biggest question before the Federal Reserve's interest rate decision on Thursday is how strongly officials will signal their willingness to cut interest rates?

The Fed is widely expected to keep its benchmark short-term interest rate unchanged at 5.25% to 5.5%, the highest level in two decades, while preparing to start cutting rates at its next meeting in mid-September.

The Fed will release its policy statement at 2 a.m. Beijing time on Thursday, and Fed Chairman Powell will hold a press conference half an hour later. Here are the four most important questions before the decision:

What criteria will officials use to cut interest rates in September?

Markets expect officials to revise their policy statement, which is discussed intensively by the 12 voting members of the Fed's rate-setting committee, to signal a September rate cut is more likely.

Timiraos stressed that seemingly minor wording changes will have important implications for the setting of the September rate cut outlook, including:

The first paragraph of the statement will describe recent inflation and labor market developments;

The second paragraph will describe the balance of risks between lowering inflation to the Fed’s 2% target and maintaining a strong labor market;

The third paragraph will lay out key language known as forward guidance, spelling out what officials need to look for before cutting rates.

Wording acknowledging the recent improvement in inflation and that risks are more balanced, along with any changes to forward guidance, would set the stage for Powell’s press conference, where he could detail how officials will approach rate cuts.

Some analysts believe Powell will leave the door open for a September rate cut without clearly committing to any course of action. "If the inflation news is OK between now and September, then they can say, 'OK, now we have confidence that things are going as planned, we're going to start cutting rates,'" said William English, a former senior Fed adviser.

Why the Fed is getting closer to cutting rates

Earlier this year, Fed officials were considering cutting interest rates based on improving inflation. Surprisingly, strong inflation data in February and March dashed those plans.

But recently, inflation has been lower than expected. In addition, the economy may be slowing more than expected, especially with the housing market stagnating and spending by lower-income consumers weak, which could give officials more confidence that higher interest rates are having the desired effect on economic activity and inflation.

“The Fed knows they are doing the right thing, that some of the weaker parts of the economy are slowing down, even though other parts are still strong, but people may say, ‘If we really want a soft landing, we should start cutting rates now because we have been in restrictive mode for a while and policy may remain restrictive even after the Fed cuts,’ ” said Raghuram Rajan, former governor of the Reserve Bank of India.

Why no interest rate cut in July?

Timiraos noted that some former Fed officials and private sector economists said that all the arguments for the September rate cut, namely that better inflation news and signs of slowing spending and hiring increased the risk of unnecessary weakness, also apply to the July meeting and the Fed should cut rates on Thursday.

Still, top Fed officials say they are not yet fully convinced that inflation is on track to fall sustainably toward the central bank’s 2% target. After the Fed’s June meeting, Powell said the first rate cut would be a “big decision” that would need to be “get it right.”

Regardless of the pros and cons of a July rate cut, most Fed officials have said it’s not the right time to cut rates. So a rate cut on Thursday “would look panicky, and I think it’s probably not helpful,” said English, now a professor at the Yale School of Management.

What happens after the first rate cut?

Timiraos said Powell is unlikely to look too far ahead at the news conference, but such considerations are likely to be an important part of officials’ private discussions this week because once policymakers have cut rates for the first time, they will face more questions about when to cut again.

Since last year, Fed officials’ quarterly economic projections have included an interest rate outlook that suggests they could cut rates by about 25 basis points every quarter once they take their first steps.

Fed officials won’t release new projections this week, but they will in September, which will allow them to show whether the previous dot plot from June is still a reasonable expectation. If the labor market weakens further between now and then, officials may initially act at consecutive meetings. The Fed will meet again in November and December. Richard Clarida, who served as Fed vice chairman from 2018 to 2022 and is now a senior adviser at Pacific Investment Management Co., said:

“If they are confident enough to act in September, then they must also act in November and December.”

Timiraos added that the Fed's rate-cutting prospects now face an awkward complication: November's two-day policy meeting will begin the day after the presidential election on Nov. 5. While the Fed has made policy adjustments during elections in the past, officials have tried to remain apolitical in making decisions. That will make their public communications more clear, predictable and thoughtful.

Article forwarded from: Jinshi Data