The Fed may have just shot itself in the foot

The Federal Reserve waited too long to lower interest rates, and now it has a much smaller reaction window if the economy suddenly turns sour.

That’s according to economist Aaron Back of The Wall Street Journal, who recently voiced his concern that not cutting rates in July “might have narrowed the Fed’s room for maneuver.”

Back cited two risks with the Fed’s current approach.

First, investors have already decided that the central bank will cut rates in September, and a small but vocal minority say it could be a larger half-percentage-point cut.

Reneging in September, for whatever reason, wouldn’t bode well for the central bank’s reputation, which suffered a major blow during the pandemic when inflation spiked to 40-year highs.

But the bigger risk “is that the Fed acts too slowly to react as signs of an economic slowdown build,” Back wrote.

The Wall Street Journal deputy editor cited “Anecdotes from Corporate America,” which pointed to an economic reality worse than the backward-looking data suggest.

These include declining consumer spending, reduced restaurant visits, and shoppers trading down for cheaper items to save a few bucks.

Is the Fed overestimating the economy?

Even the seemingly rosy economic data has painted a mixed picture of America's economic health so far this year.

After a disastrous first quarter, America’s GDP grew faster than expected between April and June.

Economists say the data looked good on the surface, but it masked much bigger issues simmering beneath the surface: Americans have depleted their savings and federal spending accounts for an ever-growing share of economic growth.

The other issue is that a portion of Q2’s strong performance was attributed to inventory calculations, which only tell us that companies produced more things that weren’t sold.

The beloved PMI indicators, which provide monthly updates on how American companies are coping, are in free fall.

The Institute for Supply Management’s U.S. Services PMI fell into contraction territory in June, posting its biggest monthly drop in four years. Services account for more than three-quarters of the U.S. economy.

Meanwhile, ISM’s latest report showed that the manufacturing sector contracted in July for a fourth consecutive month and the 20th time in the last 21 months.

For these reasons, economists say the economy is slowing faster than the Fed expects.

Strategists at Goldman Sachs and Citigroup believe the Fed will eventually get the memo. Citi’s strategists think the central bank will have no choice but to cut interest rates in September, followed by seven consecutive cuts after that.

“A continued softening of activity will provoke cuts at each of the subsequent seven Fed meetings, in our base case,” Citi’s analysts recently predicted.

If they’re correct, the federal funds rate is set to drop to 3.5% by July 2025, two percentage points lower than the current rate of 5.5%.