The scene is set for the first downgrade and confidence is growing among the FOMC members.

Summary:
The Fed made no changes to monetary policy at its July meeting as expected, and Chairman Powell avoided pre-commitment but opened the door firmly to starting rate cuts in September. The Fed sees scenarios ranging from “zero to multiple cuts this year.” The focus is on the risk of a sharp deterioration in labor market conditions, but we see no reason to panic yet.

The underlying inflation trend calls for a series of rate cuts at a measured pace to 3.375% by mid-2026. At the July meeting, we saw that the FOMC held open market interest rates steady but also stated that the economy was approaching the point at which it would be appropriate to cut rates. At the press conference, Powell emphasized that the economy does not need further weakness to justify an easing cycle, and that instead the impetus will be confidence in the continuation of the downward trend in inflation. The committee still believes it has enough time to gauge the pace of inflation and its risks.

As for the unemployment rate, it has risen but remains generally low, and at the press conference, Powell also highlighted that growth in domestic demand remains healthy so far in 2024. Further progress towards the Committee’s inflation target (2%) is therefore desirable in the third quarter before starting to ease policy.

When considering the continuation of the downward trend in inflation and the possibility of a reduction in September, the signs are that the annual consumer price index, since June 2023, has remained within a range (0.8% - 2.3%) annually and has averaged below (2.0%) annually, and inflation expectations are now in line with the decade average over one year.

According to the employment cost index, wage growth is converging to a pace consistent with maintaining inflation at the target (2.0%) annually.

Despite the fundamental strength of the economy, the economic outlook is uncertain, and the committee is alert to risks to both sides of its dual mandate, a change from the language of the previous statement that highlighted only inflation risks. The chairman emphasized at the press conference that the FOMC has the ability to adjust the pace of easing as necessary. At the moment, the market is focused on the downside risks to the labor market, which have been highlighted throughout 2024, but next year, if the fundamental strength of the economy holds, inflation risks are likely to re-emerge, domestic capacity constraints in the United States are real and could be permanent, and trade policy poses a real threat.

Westpac’s view seeks to balance these risks. We continue to expect the first cut in September, followed by one cut per quarter from 2024 to 2026. Given the FOMC’s long-term 2.8% estimate, and our slightly higher view of the likely direction of neutral interest rates, it is best to view the endpoint of the cycle as somewhat constrained. We see policy as unlikely to return to neutral or expansionary unless consumption growth weakens significantly.