In a speech during the third week of August, the Federal Reserve Board’s Federal Open Market Committee (FOMC) Chair Jerome Powell indicated that the balance of risks to the economy had shifted toward weaker growth. He added that this could warrant an easing monetary policy. The FOMC has been indicating for some time that it was likely to cut interest rates in the third and fourth quarters. Powell’s words reinforce that likelihood.
The outlooks for growth and inflation contain risks in both directions. It is the FOMC’s job to try to calibrate those risks. With respect to growth, it must balance slower job growth against rising stock prices. With respect to inflation, the effects of tariffs on goods prices will be likely be counterbalanced by decelerating shelter inflation.
Potential for Growth Slows
The economy’s loss of momentum has manifested itself in various ways. Non-farm payrolls have grown by an average of 85,000 in the first seven months of this year, down from 168,000 per month in 2024. GDP has grown at a 1.4% pace in the first half of this year after growing by 2.5% in 2024. In large part, the slowdown in growth mirrors a slowdown in the economy’s potential growth rate. The main reason for the slowdown in the economy’s potential growth rate is the sharp swing in net migration. This can be seen in the unemployment rate, which has edged up to 4.2% from 4.1% in December. In contrast, the unemployment rate rose from 3.7% at the end of 2023 to 4.1% in December 2024. The stronger growth in 2024 was not quite enough to prevent unemployment from rising.
The Federal Reserve has to assess growth relative to the economy’s potential growth rate. In that context, the slowdown so far this year must be contextualized against a backdrop that has seen much less net migration and less labor force growth. There have been hints in the past three months of a more serious slowdown. Job growth in those three months has averaged just 35,000 per month, much less than the 123,000 per month generated during the first four months of the year. Still the unemployment rate has not changed during the past three months, an indication that net migration also may still be slowing.
Inflation Drops, but Caution Still Required
Looking at the slowdown in job growth in the context of less net migration and much slower labor force growth results in a picture that suggests the Fed should be cautious about cutting interest rates too aggressively. Another factor that also points to the need for caution is the ongoing rise in the stock market. Stock prices are very high relative to fundamentals such as profits or sales. Market capitalization also remains highly concentrated among a group of five to ten companies. The current level of concentration is exceptional by historical standards. Easing monetary policy under these circumstances risks further inflating what might be an already large bubble, with an attendant rise in the risks of a destabilizing correction.
The inflation picture is somewhat more encouraging. Shelter inflation (which makes up about 40% of the non-food and energy components of the CPI) has slowed significantly from 6.2% in 2023 to 4.6% in 2024 to a 3.2% annualized rate in the first seven months of 2025. The ongoing rise in rental vacancy rates makes it likely that the slowdown in rental inflation will continue into next year. This will largely offset the effects of tariffs that have yet to be fully felt. Of course, tariffs policy continues to be a source of significant uncertainty both for the growth outlook and the inflation outlook. The most recent court decisions have called into doubt the legal basis for some of the tariffs currently in place. However, it will take some time for the legal process to play itself out. Uncertainty about tariffs will remain high for the foreseeable future.
Given the above considerations, a modest amount of easing by the Fed (25 basis points at its next meeting on September 17 and another 25 basis points in the fourth quarter) is reasonable. However, barring a significant deterioration in the labor market anything more aggressive seems unlikely.
