The Fed's Rate Cut Dilemma: Inflation or Recession?

After a nine-month pause, the Federal Reserve (Fed) appears poised to cut interest rates by 25 basis points at its upcoming meeting. However, this potential move is sparking considerable debate. What’s the core reason behind this controversy? Part of the debate stems from the economic outlook – the U.S. economy seems destined for a peculiar period of "slower growth coupled with high inflation," often referred to as stagflation. Increased tariffs on imported goods not only trigger uncertainty and drag down economic activity but also push price levels higher. Against this backdrop, economists are divided into opposing camps on "whether the Fed should prioritize addressing slowing growth or high inflation." The camp of economists concerned about high inflation advocates that the Fed maintain interest rates unchanged. The camp worried about an economic recession, on the other hand, is calling for the Fed to cut interest rates even more aggressively, especially after the weak jobs report released last Friday.

Why the Controversy Now?

Without the problem of stagflation, the reasons for a rate cut would be straightforward: to prevent the risk of further weakening of the economy by lowering interest rates. Almost everyone agrees that the current interest rate range of 4.25% to 4.5% is already sufficient to curb demand to some extent. Therefore, a rate cut might stimulate economic activity, but in a stagflation environment, a rate cut could also trigger further increases in inflation. In August, the U.S. economy added only 22,000 jobs, far below the "average monthly growth of over 100,000 jobs" in the first three months of this year. Jim Bianco, president of Bianco Research, opposes the Fed cutting interest rates, believing that adding 22,000 jobs per month might already be the best that can be achieved at present. In the past few years, based on population growth, adding about 100,000 jobs per month was considered the minimum needed to maintain a stable unemployment rate. But few mention that past population growth included a significant number of immigrant workers. With President Trump’s de facto "border closure" policy in place, the U.S. economy may only be able to provide 22,000 workers per month, which is enough to keep the job market stable. Bianco said in an interview that without additional labor supply, the Fed cutting interest rates at this time would only exacerbate inflation.

Diverging Views

On the other hand, Matthew Luzzetti, chief U.S. economist at Deutsche Bank, believes that the weak job growth this summer does not stem from limited labor supply but from the continued uncertainty shock triggered by increased tariffs, leading to weaker demand. He expects the Fed to cut interest rates by 25 basis points in September. Steve Englander, head of North America macro strategy at Standard Chartered Bank, believes the Fed should cut interest rates by 50 basis points in September. Englander said that the supply and demand dynamics of the labor market mask its true weakness. He pointed out in a research report that he does not believe the Fed will launch a series of 50 basis point cuts, but this cut should be a "catch-up" cut (i.e., compensating for the previous failure to ease in a timely manner). Ruchir Sharma, an economist at Rockefeller International, argued in a Financial Times op-ed that the Fed should actually consider raising interest rates. He pointed out that current financial conditions are extremely loose, and consumer price inflation has exceeded the Fed’s 2% target for four consecutive years and is expected to remain above that level for the foreseeable future. He said that the prevailing view that "the Fed will cut interest rates by 25 basis points" stems from a "precautionary reflex to rush to rescue the market at the slightest sign of economic weakness" – a reflex that has undermined the Fed's credibility and fueled financial bubbles for decades.