Introduction
The Federal Reserve (Fed) of the United States has decided to lower its benchmark interest rate by 25 basis points, bringing it down to 3.6%. This move is expected to create tension in the labor market and potentially accelerate inflation. The Fed had previously cut rates this year, only to reverse its stance in 2026.
Background on the Fed’s Decision
The decision to reduce interest rates was based on three key observations:
- The deterioration in job creation (the US economy has been creating an average of only 29,000 net jobs per month, and employment decreased in June)
- The subsiding inflation under the Fed’s target, albeit gradually
- The significant gap between the Fed’s benchmark rate and the interest rate at which the Fed would no longer be restraining economic growth (the neutral rate is estimated to be around 3%)
Misinterpretations by the Fed
However, the Fed’s assumptions are flawed:
- Employment Figures: Interpretation of employment figures is complicated by sudden changes in immigration patterns. The net job creation required to keep up with population growth might be less than 50,000 jobs per month. Future changes in net migration could even push this number into negative territory.
- Labor Market Rigidity: Unemployment rate, a better measure of labor market rigidity, stands at 4.3%, which is relatively low and has only increased by ten basis points in the last year.
- Wage Growth: Wage growth shows a firm, yet cooling trend, indicating that job creation statistics reflect more about the supply of laborers than businesses’ demand for workers.
Inflation Concerns
While the Fed delayed acknowledging inflation threats in 2021, its decisive response in 2022 led to a reduction in underlying inflation by mid-year. However, the core inflation rate, measured by the personal consumption expenditure (PCE) deflator, only dropped three percentage points between mid-2022 and mid-2024. In the past year, this rate has stagnated, dropping only 28 basis points between April 2024 and April 2025, surpassing the Fed’s target and moving in the wrong direction.
This acceleration might be due to one-time price hikes resulting from new tariffs. Yet, consumer spending—the primary driver of aggregate demand—remains robust. Retail sales data for August surprised analysts with a strong 5% year-over-year increase.
Economic Implications
Considering the labor market, price inflation, consumer spending, and overall economic activity, a 4.4% benchmark rate does not seem to have significantly curbed consumer or business activities. The Fed’s calculation of the neutral rate is off, and a reference rate above 4% might be necessary to control demand. However, the Fed plans to lower it to 3.6% this year and further in 2026, potentially causing labor shortages in a tense labor market and accelerating inflation.
Adding to this, President Donald Trump’s continuous threats to the Fed’s political independence add another layer of concern. If some FOMC members predict five more rate cuts before 2025, ending with a benchmark rate below 3%, inflationary pressures could intensify, increasing the likelihood of rate hikes in 2026.
Conclusion
The Fed seems to be fighting the last war, focusing on post-2008 financial crisis weaknesses in the labor market and low neutral interest rates. However, today’s economy is vastly different, and the Fed has yet to win the recent battle against inflation’s return.
Key Questions and Answers
- Q: Why is the Fed lowering interest rates? A: The Fed aims to address a perceived weak labor market and subsiding inflation.
- Q: What are the potential consequences of these rate cuts? A: The Fed risks tightening the labor market and accelerating inflation, potentially needing to raise rates again in 2026.
- Q: How accurate are the Fed’s assumptions about employment and inflation? A: The Fed’s interpretations of employment figures and inflation are clouded by immigration changes and may be overly optimistic.
