With the presidential election coming up this year, President Biden, like his predecessors, is calling for the Federal Reserve to cut interest rates, which would not only stimulate financial markets but also signal the Fed's confidence that it has won the battle against inflation. Unfortunately for Biden, the weaker-than-expected labor market report released today was not weak enough to give confidence that the Fed will begin cutting interest rates by November.
Since the Fed's last rate hike in July 2023, Chairman Jerome Powell has remained consistent in his monetary policy message. The Fed will not begin cutting rates until it is confident that inflation has sustainably fallen to its 2% inflation target. He has also expressed disappointment that inflation has been more resistant than expected to Fed rate hikes. Consumer price inflation has fallen significantly from a high of over 9% in July 2022 and has stagnated at just over 3% in recent months.
In the Fed's worldview, a key determinant of inflation is the state of the labor market. When the labor market is hot and unemployment is very low, wages tend to rise, leading to higher inflation. Similarly, when the labor market is cold and unemployment is rising, this puts downward pressure on wages, leading to lower inflation.
Chairman Powell indicated at his last press conference that the labor market remains strong. Today's employment report does not significantly change that picture. To be sure, payroll growth was slower than expected, at 175,000 new jobs. However, this comes after several months of robust payroll growth of 300,000 jobs. Similarly, while the unemployment rate rose to 3.9%, this rate is near its lowest in the postwar period. Such a low unemployment rate is not likely to align with sufficient moderation in wage growth to sustainably bring inflation down to the Fed's 2% inflation target.
As a result, the Fed could cut interest rates at its next two policy meetings without undermining its credibility in the market as a tackling source of inflation. The outlook for rate cuts later this year will be complicated by the looming November election. To avoid suspicions of political interference, the Fed would need a compelling reason to cut rates on the eve of an election.
Another important reason Biden should be worried is that the Fed now has to keep interest rates high for a long time, which could trigger a financial crisis on the eve of the election, as happened with Lehman Brothers' collapse in September 2008.
This time, the Fed's high interest rates could be another contributing factor to the regional banking crisis. These banks have already suffered large mark-to-market losses on their bond and loan portfolios as a result of high interest rates. They also have a large exposure to the troubled commercial real estate sector. A warning sign that these banks could be in serious trouble by the end of the year is the skyrocketing commercial real estate default rates. With roughly $900 billion of commercial real estate loans having to be refinanced at much higher interest rates than they were originally contracted at, we should expect to see more commercial real estate loan defaults.
Bill Clinton's political adviser James Carville famously said that when it comes to the election, “it's about the economy.” With little prospect of interest rates falling anytime soon and inflation still hovering above 3%, Biden must be hoping that James Carville is wrong.