Why the Fed is moving closer to a rate cut

There's been a lot of debate about whether the Federal Reserve System (Fed) should cut or increase interest rates. The year started with expectations that the Fed would need to cut rates several times throughout the year. Then the Iran conflict kicked off in February, causing a resumption of higher prices, especially at the gas pump.

A re-surging Consumer Price Index (CPI) then shifted the discussion to why the Fed might need to increase interest rates, with several Fed officials voicing their support for rate increases. At the most recent Fed meeting, there were three dissents against the decision to leave rates unchanged, with all three supporting a rate increase.

In my last column, I suggested that the Fed should, in fact, hold, but that there was a chance we could see a cut by the end of this year. Based on some of the recent economic data, we are moving closer to that happening.

The last employment report showed the economy lost 23,000 jobs in July. This was a big miss, with economists expecting a sizable increase in payrolls. Even worse, May and June payroll numbers were revised downward by a combined 103,000 jobs, putting both months at an average of only 41,000 jobs.

The year started out with stronger payroll gains, with gains in three out of the first four months exceeding the payroll gain of any month in 2025. Since then, job growth has been less than impressive.

Not only have payrolls been sluggish, but employment from the household survey has also been moving in the wrong direction. Employment fell in July by 87,000 and is down by around 1 million from last year. That means about 1 million fewer workers are employed than a year ago.

Part of this is due to a shrinking labor force. The nation's labor force is down about 1.4 million from last year, and the participation rate, the percentage of the working-age population either employed or looking for work, is down almost a full percentage point from last year.

Fewer workers available makes it more difficult to create jobs. You can't create a job if there is no worker to fill the position. A declining labor force will push employers to rely more on capital instead of labor, boosting things like productivity and profitability, both positives for the economy.

Our mid-year economic outlook back in May expected regional payrolls, particularly Louisville Metro, to pick up. This was largely due to the signals we saw in manufacturing. There was at least one positive in the last jobs report, and that was in manufacturing.

Manufacturing added 5,000 jobs across the nation. While this is not a large number, manufacturing is finally seeing a turnaround from the dismal growth of the last few years. Manufacturing payrolls are beginning to pick up, and this will come as good news for states like Indiana and Kentucky. We are not going to see massive gains in manufacturing jobs, but the region should see a pickup in employment due to activity in manufacturing.

The other reason the Fed is likely to hold at its September meeting, setting itself up for a possible cut later this year, is on the inflation front. Inflation is on the downward slope again. Prices are not declining, but the rate of change is getting smaller. Over the past three months, the headline CPI has increased by only about 0.2%. Annualized, that puts the recent pace of inflation at less than 1%. We get the same result if we remove the cost of food and energy.

If we continue to see weak payroll growth, as we have over the past couple of months, along with continued improvement on the inflation front, the argument for keeping interest rates elevated will become increasingly difficult to make. Another weak jobs report could be enough to move the Fed from holding rates steady to cutting them before the end of the year.

Editor's note: Dr. Uric Dufrene, Sanders Chair of Business and Special Assistant to the Chancellor for Talent and Workforce Development at Indiana University Southeast, is a frequent speaker and media contributor on local and regional business and economic trends.