Economic Update | First Interest Rate Cut Coming in September, or Maybe July

submitted by
Uric Dufrene, Ph.D., Sanders Chair in Business, Indiana University Southeast

After a rocky start to the year, inflation appears to be heading in a downward trend again. After peaking during the middle of 2022, inflation then began a steady ride down. Supply chain issues, one of the causes of the inflationary spike, were being resolved, and this showed up as disinflation in big ticket items such as cars and trucks. As 2023 came to an end, inflation continued to move in a favorable direction, and the Fed opened the door to cuts during 2024.  At the start of the year, the Fed indicated that the economy could expect three cuts to the Federal Funds rate. The market was even more optimistic as it was expecting six cuts across 2024. Disinflation saw gains in consumer indicators like consumer sentiment, rising from a 50-plus-year low.    

Then as 2024 began, inflation was proving to be stickier. The first quarter saw inflation coming in higher than expected, leading the Fed and market to back off the number of anticipated interest rate cuts for this year. Six expected cuts by market participants declined to two, and the Fed signaled a decline from three to one cut for 2024.   

The past couple of months have produced inflation reports that were more favorable for pending interest rate cuts. Inflation was weaker than expected, and odds are now favoring the first cut to occur in September. With a labor market that continues to show some signs of softening, additional weak readings in inflation could eventually result in three rate reductions this year, higher than what current market participants are expecting. 

Declining inflation matters to consumers because of the impact on prices paid. Consumers also feel the sting of inflation with higher interest rates, from credit cards to car loans and mortgages. The barometer rate to watch here is the 10-year Treasury yield, a key determinant of interest rates paid by consumers, and strongly influenced by expected inflation. As inflation falls, interest rates on the 10-year yield will follow.  This means lower interest rates for consumers, particularly mortgage rates. Back in October 2023, the 10-year yield almost crossed the 5% threshold, peaking at 4.92%. Mortgage rates almost surpassed 8%, stopping at 7.9%.  With the most recent slide in the 10-year yield, mortgage rates have also declined, now just under 7%. 

So, what happens to inflation will have a lot to say about Federal Reserve actions on interest rate reductions and the 10-year yield.  The Fed will see another employment report and CPI before the next July meeting.  If inflation comes in weaker than expected, look for the first cut in September.  If we get a weak employment report, with either a weak payroll number or a noticeable uptick in the unemployment rate, look for the odds of a July cut to increase. If we see no Fed action in July,  two to three cuts are likely for the rest of the year.  The combination of a softening labor market, weaker consumer spending, and inflation that approaches the preferred 2% rate will provide the go-ahead for the Fed to begin easing.  The presence of the November election puts the first cut in either July (currently low probability) or September.  This provides an option for subsequent cuts or another pause.  Waiting until November throws politics into the mix, and this is what the Fed will want to avoid. Expect a first cut in either July or September.

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