A central bank at rest tends to stay at rest

By Thomas Garretson, CFA

So goes Newton’s first law of motion: an object that is not moving will remain stationary unless a force is applied to it. And if one thing was clear from this week’s Fed meeting – absent an outside force – the Fed is more than content to remain at rest by keeping rates unchanged.

The Fed left its policy rate at a target range of 4.25–4.50 percent for the fifth consecutive meeting, as was widely expected. In his press conference, Fed Chair Jerome Powell summed up the justification for doing so succinctly, “It seems to me, and to almost the whole committee, that the economy is not performing as if restrictive policy is holding it back inappropriately. Modestly restrictive policy seems appropriate.”

We find that sentiment hard to argue with. When the Fed delivered the first of a series of rate cuts last September, core PCE inflation was running at an annual rate of 2.7 percent; as of this morning’s release for July data, that pace has picked up slightly to 2.8 percent. Similarly, the unemployment rate was 4.1 percent last September and has continued to hold steady around that level this year.

So, with little changed with respect to both sides of the Fed’s mandate of price stability and maximum employment, it seems to us the inertia behind current policy rates will remain. Market expectations of a rate cut now imply less than a 50 percent chance of a move, compared to nearly 70 percent prior to the meeting. We now expect a rate cut by December at the earliest.

Outside, and inside, forces

While the meeting was short on any real surprises, there were two notable developments: Powell’s perceived hawkishness and two dovish policy dissents from governors.

On the first, Powell was quick to note that the potential inflationary impacts of tariffs are likely only just beginning. With more trade deals announced this week, and many tariffs finally to be implemented as of August 1, it will likely still take several months for any impact to show in the data. He also pointed out that rising goods prices, and potential for them to rise further, could arguably justify rate hikes.

Beyond tariff risks, we think there’s another factor behind the Fed’s hawkish tone this week – financial conditions have rarely been this easy and are now nearly the easiest since the Fed started raising rates in 2022. Record-high stock indexes, tight corporate credit spreads to Treasury yields, and a weakening dollar are financial factors that could pose upside risks to inflation while bolstering economic activity. We believe cutting rates when financial conditions are already this easy amid a solid economic backdrop would likely amplify those risks.

Easy financial conditions no condition to cut rates

Goldman Sachs Financial Conditions Index

In the other direction, an outside force attempting to exert downward energy on rates is, of course, President Donald Trump. His attacks on Powell continued this week, but following recent developments with the Fed’s renovation project, we think near-term risks of his firing “for cause” have faded. We still hold some reservation, particularly if the Fed stays on hold until December, that the President’s patience could run thin and that things could reach a boiling point.

Finally, there were inside forces acting on the Fed at this week’s meeting. Governors Christopher Waller and Michelle Bowman dissented at this week’s meeting in favour of lowering the policy rate by a quarter of a point.

It’s the first time that two governors, of the seven that typically comprise the board, have dissented since 1993. As a practical matter it doesn’t matter much, and differing views are welcomed at the Fed, but Powell’s hawkish tone suggests to us that they remain outliers at the Fed and that the core of the committee supports the ongoing wait-and-see approach.

That said, Waller has been the most outspoken on rate cuts, making the case that the Fed should move to get ahead of looming labour market risks – but does he have a case?

Working hard, or hardly working?

Labour market data, by and large, remain solid – but mixed. As noted, the unemployment rate has remained flat, if not edged lower, this year as moderating labour demand has been offset by a modest decline in the labour supply.

While there are numerous data measures to track, one of the best to our eyes is consumer labour market sentiment. The percentage of consumers viewing jobs as “hard to get” has one of the higher correlations with the official unemployment rate.

Cooling consumer labour market sentiment suggests upside risk to unemployment rate

An index of the percentage of people seeing jobs as “hard to get” rose this week to 19 percent for July up from around 14 percent at the start of the year, despite the unemployment rate remaining flat. Historically, when that index has been around 20 percent, the unemployment rate has been closer to five percent. We certainly don’t see unemployment rising to that level anytime soon, but it suggests upside risk to the current unemployment rate of 4.1 percent, beginning with tomorrow’s Nonfarm Payrolls Employment report for July.

In our view, it simply reflects a normal decline in sentiment that tends to come at the later stages of most economic expansions and is not yet a sign that the labour market is near the point of cracking.

A return of “higher for longer”?

Absent an outside force, we think the inertia behind the current level of interest rates is likely to remain.

Recent stock and corporate bond market rallies have been fueled, at least in part, by market expectations that although rate cuts have been delayed, it would only mean more rate cuts next year.

While we currently anticipate multiple rate cuts in the pipeline from the December meeting moving forward, it was only back in March that RBC Capital Markets analysts projected no rate cuts through 2026. With the worst of the tariff threats now seemingly in the rearview mirror and steady economic performance, the bias could be back toward that type of outcome.