By CICC

At its September meeting, the Federal Reserve cut rates by 50 basis points, with its monetary policy statement emphasizing the goal of maximum employment. The Fed's actions indicate that its reaction function has shifted entirely from focusing on inflation to prioritizing employment. Officials have little tolerance for rising unemployment and do not want to jeopardize the positive outlook for a "soft landing" due to excessive tightening. Looking ahead, we believe the Fed will likely maintain a "dovish" stance until the labor market stabilizes. In the short term, the rate cuts increase the likelihood of a soft landing in the U.S., but the combination of "loose fiscal and monetary policies" could also raise medium-term inflation risks.

This meeting came against the backdrop of slowing inflation in the U.S. over the past two months, coupled with signs of weakening in the labor market. The market was eager to see how the Fed would respond to these marginal changes and what its reaction function would be. Before the meeting, the market had fully anticipated the rate cut, with uncertainty only about whether the reduction would be 25 or 50 basis points.

The rate decision revealed a more aggressive 50-basis-point cut by the Fed, exceeding our expectations. The monetary policy statement noted that recent inflation data has given policymakers more confidence in achieving the 2% inflation target. At the same time, with the unemployment rate rising, the Fed also emphasized its commitment to the goal of maximizing employment ("The Committee is strongly committed to supporting maximum employment...").

The Fed's actions signal that its reaction function has shifted completely from inflation to employment. Fed Chair Jerome Powell stated at the Jackson Hole meeting in August that "further cooling of the labor market is unwelcome." The mixed August nonfarm payroll report followed, showing a decline in the unemployment rate from July but continued slowing in job growth. It is clear that Powell saw this shift as triggering the conditions he had warned about, prompting the Fed to deliver on its commitment with a 50-basis-point rate cut at this meeting.

Although Powell denied declaring victory over inflation during the press conference, he now appears to be focused solely on employment. He stated that he hopes the unemployment rate will remain at its current level and not rise further. Fed officials also predict that the unemployment rate will rise by another 0.2 percentage points to 4.4% by the end of this year, remaining around 4.4% through 2025 and 2026.

We see this as a signal that the Fed has little tolerance for rising unemployment, and officials are unwilling to risk derailing the positive outlook for a soft landing. Based on Powell's remarks, we believe that any unemployment rate above 4.4% could trigger further rate cuts. This also suggests that the Fed will likely maintain a dovish stance until labor market data stabilizes. According to the latest dot plot, 10 out of 19 officials predict at least two more rate cuts by the end of the year, 7 expect just one more cut, and 2 expect no further cuts. This shows that the majority of officials are inclined toward further rate cuts to keep the unemployment rate within the full employment range of below 4.4%.

However, this 50-basis-point cut was not a unanimous decision. Of the 12 voting officials, 11 voted in favor, with Board Member Bowman dissenting, favoring a 25-basis-point cut. This is the first time since 2005 that a Fed governor has voted against a policy decision. Another subtlety is that after the August nonfarm payroll report, Fed officials did not explicitly signal a 50-basis-point cut until the news leaked after the "quiet period" began last week, indicating that policymakers had been hesitant about the size of the cut.

Looking ahead, with the Fed adopting a more aggressive rate cut, the likelihood of a soft landing has increased further in the short term. In our earlier report "Economics and Policies Toward a Soft Landing," we noted that soft landings in history often accompanied rate cuts, as moderate adjustments in monetary policy after aggressive tightening help avoid over-tightening. This time, with supply factors improving and short-term inflation risks under control, the Fed's rate cuts will support demand expansion, and U.S. economic growth may continue at a high pace, further boosting the chances of a soft landing. The Fed's latest forecast lowering its inflation projections while keeping growth forecasts unchanged also reflects its confidence in a soft landing.

However, in the medium term, the combination of "loose fiscal and monetary policies" in the U.S. could increase inflation risks. The latest data from the U.S. Treasury shows that the fiscal deficit increased to $380.1 billion in August, up by $136.3 billion from the previous month and by $469.3 billion compared to the same period last year. The year-on-year increase in the August fiscal deficit was the highest in the past three years. Additionally, the cumulative fiscal deficit for January-August 2024 reached $1.39 trillion, up by $280 billion compared to the same period last year, an increase of 25%. These figures indicate that fiscal policy has not tightened this year but rather continued to expand. Expansionary fiscal policy already has the effect of boosting the economy, and combined with the Fed's aggressive rate cuts to lower unemployment, it could lead to the economy returning to a "no landing" scenario in the medium term. If supply factors do not improve, the rebound in demand may push inflation higher. Following today's Fed meeting, U.S. Treasury yields rose instead of falling, and the yield curve steepened, possibly reflecting market concerns about the long-term inflation risks posed by the Fed's aggressive rate cuts.

Chart 1: The Federal Reserve's September Interest Rate Dot Plot

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