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The Federal Reserve's path to rate cuts has never been clearer since 2020, and that path will face its first test on Friday.

Federal Reserve Chairman Jerome Powell signaled the U.S. central bank will cut interest rates in September unless inflation progress stalls, and he noted the risk of further weakness in the labor market.

Powell said policymakers were closer to lowering borrowing costs from more than two decades high, underscoring the Fed’s growing confidence in its ability to ease restrictions on the economy. However, he cautioned that the Fed would agree to cut rates if price data in the coming months disappointed.

“The changes in the statement and the press conference are basically telling you that there will be a rate cut in September unless there is a material change in the economic outlook,” said former New York Fed President William Dudley.

The Federal Reserve's Open Market Committee on Thursday kept the federal funds rate in a range of 5.25% to 5.5%, a level it has maintained in agreement since July last year.

“The question will be whether the aggregate of the data, the changing outlook, and the balance of risks are consistent with greater confidence about inflation and a solid labor market, which would warrant a reduction in our policy rate at our next meeting in September,” Powell told reporters.

The post-meeting statement tweaks, along with Powell’s comments, underscored policymakers’ growing concerns about excessive weakening of the labor market, a shift from their more than two-year focus on inflation .

“The economic outlook is uncertain, and the committee is closely monitoring risks to both sides of its dual mandate,” policymakers wrote. Previously, their language had been more focused on inflation risks.

Powell described the labor market as solid but slowing, with hiring slowing and the unemployment rate rising to 4.1%, the highest level since 2021 but still historically low. Layoffs remain rare. But he said the labor market does not need to soften further for the Fed to achieve its 2% inflation goal. Powell said at a press conference:

"We've seen a very significant reduction in inflation while unemployment remains very low," he said, adding that this was an unusual and welcome outcome. "What we've been thinking about is, how can we make this sustainable?"

Has the labor market become the “top priority”?

The Fed is determined to lower inflation without triggering a recession, but Powell also emphasized the delicate balance between cutting rates too early and too late, saying that by starting to cut rates in September, perhaps before inflation has fully returned to 2%, they could build in some "safeguards" to prevent a significant deterioration in the labor market.

“The inflation problem is not solved, but we can nonetheless begin to reduce the constraints imposed by our policy interest rate,” Powell said.

Raising labor market risks to the same level as inflation reflects the dual political and economic pressures on the Fed.

A rise in unemployment at a time when 2% inflation is on the horizon, especially after the Fed acted too slowly as inflation rose, would not only draw criticism but also damage the Fed’s credibility with the public.

Markets took the news in stride, with U.S. Treasuries rising after Powell’s press conference. Interest rate swaps showed traders had fully priced in a 25 basis point rate cut in September and nearly 70 basis points of total rate cuts this year.

" Unless there is a significant reversal in inflation data, a rate cut in September cannot be ruled out, " said Diane Swonk, chief economist at KPMG.

Still, a September rate cut is not set in stone. While inflation, the Fed’s preferred measure, rose 2.5% in the 12 months through June and has been trending lower, policymakers are concerned about inflation stagnating as it did at the start of the year. Powell said he could “envision a scenario where there are multiple rate cuts over the rest of the year depending on how the economy evolves.”

Analyst Nicholas Jasinski pointed out that the Federal Reserve's path to rate cuts has never been so clear since the 2020 epidemic, and this path to rate cuts will face its first test on Friday .

First up is the July non-farm payrolls data, which will be released on Friday. The market expects non-farm payrolls to increase by 175,000 in July , compared with 206,000 in June. The unemployment rate is expected to remain unchanged at 4.1%. August employment data will be released on September 6.

As for inflation data, the next two dates are August 14 and 30, when July CPI and PCE data will be released, respectively. Officials will also see August CPI data on September 11 before the FOMC meeting on September 17-18. August PCE data will not be released until September 27. ADP Chief Economist Nela Richardson said:

“This is a Fed that wants to give itself as many options as possible, and the worst the Fed can be in is being backed into a corner, and the good thing for the Fed is that unemployment is persistently low, so they can afford to wait.”

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