The Fed should not cut interest rates yet

With inflation cooling and unemployment rising in the United States, investors are betting that the Federal Reserve will cut interest rates.

- MICHAEL R STRAIN

At the time of this writing, market prices imply a less than 2 per cent chance that the Fed will not reduce rates at its policy-setting meeting in September, and even indicate a 7 per cent chance that it will lower rates at the next meeting later this month.

The argument for cutting rates is straightforward. As measured by the consumer price index (CPI), the US experienced no inflation in May and deflation in June. At the same time, the unemployment rate has been trending up since last summer. At 4.1 per cent, it is 70 basis points above its post-pandemic low. When the unemployment rate goes up a little, it goes up a lot, which is why many believe that the Fed should declare victory in its battle with inflation and begin its cutting cycle. But this view, while reasonable, is mistaken, because it misreads the outlook for inflation and the labour market. The Fed should not cut rates in September, and certainly not this month.