Investors are betting the Fed will use its July meeting to set the stage for a September cut

　　Most Federal Reserve watchers dont expect the central bank to ease monetary policy this week in Washington DC, but what they do expect is that policy makers will set the stage for an interest rate cut at their next meeting in September.

　　Fed officials have said they are getting closer to having confidence inflation is sustainably dropping to their 2% goal. They have also said they are paying more attention to rising unemployment, another sign that cuts may be nearing.

　　But most Fed watchers say the central bank still needs just a bit more time to be sure, while also preparing the markets for the significant action to come.

　　“The pressure is growing for them,” said former Kansas City Fed president Esther George. “I think that they are going to look at September very seriously. Its looking to me like we are coming to a time where that decision is more important and it's why I'm more confident.”

　　The latest reassurance that a cut could be nearing came Friday when a new reading of the Feds preferred inflation gauge — the core Personal Consumption Expenditures (PCE) Index — showed its lowest annual gain in more than three years.

　　The 2.6% annual increase in the month of June was the same level as May and down from 2.8% in April. On a three-month annualized rate, core PCE dropped back to 2.3% from 2.9%.

　　Another inflation measure, the Consumer Price Index (CPI), has also shown progress.

　　On a “core” basis — which excludes volatile food and energy prices the Fed cant control — CPI rose 3.3% year over year in the month of June. That was down from 3.4% in May and 3.6% in April.

　　Thus at the conclusion of this week's policy meeting on Wednesday, “the Fed will say to the effect that the recent economic data, especially the inflation data, has given them the confidence that inflation is likely returning to their target and that reducing rates would be appropriate soon,” said Wilmington Trust chief economist Luke Tilley.

　　'Why wait？'

　　Some Fed watchers do argue the Fed has the basis to support a cut at its meeting this week, even as they note they dont expect it to happen.

　　“I don't see a reason within the economic data that they should not cut this meeting,” Tilley said. “In fact, I think it's hard to see a reason that they should keep rates where they are.”

　　That said, theres “no way” the Fed would do that, Tilley added, because it runs the risk of “spooking the markets.” He predicts one cut in September and another in December, followed by a total of six quarter-point cuts in 2025.

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　　A cut this week would, in fact, come as a near-total surprise to markets. Traders currently are estimating just a 5% chance of a cut this week, compared with a near total chance of a cut at the September 17-18 meeting.

　　But Goldman Sachs chief economist Jan Hatzius is another observer who also sees a solid rationale for cutting in July.

　　“If the case for a cut is clear, why wait another seven weeks before delivering it？” Hatzius said in a research note.

　　“Second, monthly inflation is volatile and there is always a risk of a temporary re-acceleration, which could make a September cut awkward to explain. Starting in July would sidestep that risk.”

　　Federal Reserve Chairman Jerome Powell. (Tom Williams/CQ-Roll Call, Inc via Getty Images) (Tom Williams via Getty Images)

　　Another reason why September is more likely is that Fed officials have indicated they need more than one quarters worth of good data to know for sure that inflation is traveling in the right direction. They may want to see what the July and August readings show first.

　　“I do think they're going to strain hard to say September is probably the time, but they're going to have to be careful with their language so they don't commit without seeing the August data,” George said.

　　A tight rope

　　Another factor that could influence when the Fed cuts is a cooling in the labor market. The unemployment rate has ticked up for two consecutive months to 4.1% — above where some Fed officials predicted the rate would be at the end of this year.

　　This is important because the Fed has a dual mandate to maximize employment in the US while maintaining stable prices. Fed Chair Jay Powell had made it clear the central bank is focusing more on the labor side of that mandate as inflation comes down.

　　Chicago Fed President Austan Goolsbee told Yahoo Finance earlier this month that the cooling of the job market is an “area of concern” and “one to keep your eye on.”

　　While there are some other warning lights, he added, so far this isnt looking like the beginning of a recession. Rather, it looks more like a labor market coming back into better balance following the shocks of the pandemic.

　　Tilley doesnt expect the job market to get much worse from here. He is projecting the unemployment rate rises to 4.5% by the end of the year from 4.1% currently, as more people enter the job market for the first time, those who had been out of the job market re-enter and others lose jobs.

　　But George isnt convinced a soft landing is a sure bet and thinks the recession is coming at some point. The momentum of people joining the job market is starting to sag, she said, and that indicates a slowdown.

　　Kansas City Fed President Esther George, left, when she was Kansas City Fed president in 2018, alongside Federal Reserve Chairman Jerome Powell, right, and New York Fed President John Williams, middle. REUTERS/Ann Saphir (REUTERS / Reuters)

　　In an election year “if you let unemployment spin up for a reason that doesn't seem well connected to the inflation story, I think that would be a hard message to the public,” she added. “This is a tight rope for them.”

　　There is a concern that the Fed could in fact keep monetary policy too tight for too long, thus causing a recession.

　　“The Fed has a history of keeping rates too tight for too long, causing a recession perhaps and then keeping them too low after the recession has bottomed out,” Tilley said.

　　But as long as the Fed telegraphs a rate cut for September, what happens this week shouldnt present any risk to the economy because the Fed's signal will cause government bond yields and borrowing rates to move lower.