Did the Fed just make a policy mistake?

The US Federal Reserve left interest rates unchanged last week.

However, it left financial markets in no doubt that a cut is imminent, with Chair Jerome Powell noting one might be on the table at the next meeting in September.

But will that prove too late, and did the Fed just make a mistake by not cutting last week?

After all, inflation increasingly looks to be under control in the US.

The Feds preferred inflation gauge rose at an annual pace of 2.5 per cent at last count, the lowest since March 2021 and just half a per cent above its target.

The annualised three-month average has fallen to just 1.6 per cent, with forward indicators suggesting the disinflationary trend will continue.

This progress could already justify a first cut, especially when one considers the outlook for inflation and the lags in monetary policy changes.

A “soft landing” is always the goal when a central bank embarks on an interest-rate hiking cycle to knock inflation on the head.

That means getting price increases under control without causing a recession or major economic slowdown in the process.

To achieve it, policymakers need to ensure unemployment doesn’t rise too much, even though they’re actively trying to constrain activity.

It’s a difficult needle to thread, and central banks have a mixed track record.

There are a few exceptions, such as the US hiking cycles of 1984 and 1995, but most of the time when interest rates rise sharply, a recession follows.

A key to success is getting the timing of the eventual easing cycle right, and that’s no easy task.

Cut too early and you appear soft on inflation, potentially risking a reacceleration. Cut too late and the economy will suffer more than is necessary, increasing the likelihood of recession.

Right now, it’s the latter which is worrying investors.

Those concerns came into sharper focus in the days following the Fed’s decision, after a string of weaker economic data, particularly the July jobs report.

We saw a surprise jump in the unemployment rate to 4.3 per cent, the highest since October 2021 and well above the 54-year low of 3.4 per cent from early last year.

That triggered a closely-watched economic indicator called the “Sahm Rule,” named after economist Claudia Sahm.

It purports that if the three-month average of the unemployment rate rises half a per cent above its low from the prior 12 months, the US economy is in recession (or close to it).

There’s never been a time this has happened since 1945 without a recession occurring, and the Sahm rule has never given a false signal.

With a 100 per cent hit rate across the past 12 recessions, you can see why investors took notice.

Despite the impressive record, this doesn’t guarantee a US recession is on the cards.

Sahm didn’t come up with this as a forecasting tool, it was to help policymakers act more quickly and send out stimulus checks automatically.

She’s downplayed the recession talk in recent days, pointing out that high immigration and lasting aftershocks from the pandemic have distorted the numbers slightly.

While the speed at which the unemployment rate is rising is cause for concern, those issues may have artificially magnified the increase.

However, the Fed should take note.

Inflation is headed toward its target, and cracks are appearing across the economy.

A recession isn’t upon us, but the risks of one are increasing.

To improve its chances of threading the needle, the Fed should’ve cut last week rather than waiting until later in the year.

Let’s hope that doesn’t prove to be a policy mistake.

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