The Fed is preparing for rate cuts, but waiting on job losses

During Wednesday’s FOMC press conference, Jerome Powell discussed how the economy was performing well before the trade war began and acknowledged that the tariffs were much larger than anticipated. As a result, the Fed has increased its projections for the risk of higher unemployment and inflation. 

This development isn’t surprising, as the impact of significant tariffs can lead to shortages in the short term. During the Q&A session, Powell emphasized that if the labor market deteriorates, the Fed has the ability to cut rates appropriately to mitigate the labor damage. However, they need to see evidence of a weakening labor market before considering more than the two rate cuts anticipated at the beginning of the year.

Labor data Is hard data

Powell discussed the importance of waiting to see if economic data worsens, as the Federal Reserve needs to balance labor data with inflation data that will be released over the next year. The uncertainty surrounding potential trade deals is creating challenges for the Fed. However, it was evident today that if the labor market declines, the Fed will take action. 

Powell mentioned that they closely monitor a series of labor statistics, but jobless claims will be the key indicator prompting a response. If the jobless claims data approaches 323,000 based on the four-week moving average, the Fed may act more swiftly than anticipated, as evidenced by today’s meeting, when he discussed the rate cuts in 2024:

Powell: “The 2024 rate cuts weren’t preemptive… If anything, it was a little late.”

The Fed acted quickly toward the end of last year because it saw the labor market getting softer than it liked, and its policy was very restrictive in its own model. I believe The Fed will act swiftly again once they can visually see the labor market breaking, as they’re modestly restrictive today with their policy.They need to see the data breaking before they act with some urgency.

Conclusion

As someone who created the labor-over-inflation model in 2022, I was pleased to hear about the importance of labor in Powell’s remarks today. He acknowledged that the Fed was late when cutting rates in 2024, as the labor market was getting softer than they first thought. He also mentioned that the labor market had stabilized before the trade war started and that the economy was on solid footing for the first few months of the year.

Regarding trade war inflation, we have to remember that it is a different setup than the pandemic inflation. Without an excessive rise in rent and oil prices, it is difficult for overall inflation to spiral out of control, as wage growth has slowed recently. These three factors could justify the Federal Reserve lowering interest rates more quickly if the labor market weakens.

Additionally, the inflation resulting from tariffs can be managed through trade agreements, making the concern about inflation in the long term less of an issue. As you can see, it’s a bit of a tricky act the Fed has to pull off for the rest of the year; however, it sounded to me 100% that if labor breaks, they will focus more on that than trade war inflation.