The U.S. economy is strong by one measure. Why the Fed is set to lower borrowing costs anyway.

By Jeffry Bartash

Fed expected to cut interest rates as it fears a weakening labor market

A giddy Wall Street projects the Federal Reserve will dramatically reduce interest rates over the next year, even though the U.S. economy seems to be growing rapidly. Odd? Not at all, economists say.

Gross domestic product, the official scorecard of the economy, could rise at a strong 3% annual pace in the third quarter, the latest forecasts show. Nor does a recession seem to be brewing.

"The risk of the economy careening into recession is somewhere between small and nonexistent," contended Stephen Stanley, chief economist at Santander U.S. Capital Markets.

Typically, a strong economy adds to inflationary pressures and necessitates higher rates. So why is the Fed primed to slash borrowing costs?

Simple: The rate of inflation, now at 2.5%, has actually slowed toward low prepandemic levels. And unemployment has risen to a more than three-year high.

Economists point out that the Fed is required by Congress to make sure inflation stays low and employment stays high - the so-called dual mandate.

The Fed's biggest worry right now is the labor market, not inflation. Job openings have tumbled, hiring has slowed and more people are ending up unemployed.

The jobless rate has risen to 4.2% from just 3.4% a year and a half ago.

"You don't have to look far for evidence of labor-market weakening," said Will Compernolle, macro strategist at FHN Financial. "And that is part of the Fed's dual mandate."

The central bank is not required to react to changes in GDP, economists note, unless they affect consumer prices or the labor market. Right now, there is little evidence of that.

Another problem with GDP is that it often gives an incomplete picture of the economy or what troubles it might be facing.

Take an episode in 2019, early in the tenure of current Fed Chair Jerome Powell: The central bank cut interest rates despite strong GDP because it worried a U.S. trade war with China would damage the economy.

Sometimes the details of the GDP report show the economy is weaker than it appears. Other times it exaggerates the strength of the economy - and that may be the case right now.

"There are pockets of stress in the economy," said Richard Moody, chief economist at Regions Financial.

The housing market, for example, has been depressed by high mortgage rates. Manufacturers have been in a slump for more than a year. And small businesses are feeling greater stress from steep borrowing costs.

"You can identify areas where the economy is slowing," Moody said. "Whether it turns up in GDP is a separate matter."

That's not to say GDP is irrelevant. If the U.S. continues to grow at an above-trend pace, the Fed might not cut interest rates as much as Wall Street expects.

The CME FedWatch Tool shows expectations of the central bank's benchmark rate being reduced to as low as 2.75% to 3%, from the current level of 5.25% to 5.5%.

Others, like Moody, think the Fed could end up closer to 3.5%.

Whatever the case, a substantial reduction in borrowing costs is warranted. U.S. interest rates minus inflation are at the highest level since 2006 and are restraining economic growth.

"They are very restrictive right now," Compernolle said.

-Jeffry Bartash

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

09-18-24 0830ET

Copyright (c) 2024 Dow Jones & Company, Inc.