Why is the Fed Likely to Cut Rates Even When Things Look Stable?

The dollar’s strength is often viewed as a function of the Fed's stance, and there’s a strong argument for rate cuts coming sooner than many expect . While we've seen some hawkish comments from Fed officials, suggesting caution due to potential inflation relapse, the underlying data points toward the Fed needing to act to prevent a deeper economic slump . We should look closely at two key factors: inflation and employment .

Regarding inflation, the core components driving the CPI and PCE—housing costs (shelter) and oil prices—are showing structural trends toward stabilization . New rental data suggests that shelter components will act as a downward pressure on inflation well into next year, and global analysts project oil prices will settle around the $50 band due to inventory levels and supply concerns . What's surprising here is that despite these disinflationary trends, US companies are not yet massively passing on cost pressures to consumers. Instead, they are absorbing them through margin compression, which is evident in the rapid reduction of margins across durable goods sectors . Given tax breaks available under the current administration, the likelihood of an immediate, sharp consumer price surge remains low for now .

The biggest driver for the Fed, however, is the employment picture, despite the unemployment rate appearing deceptively low . Structural changes, such as tighter immigration policies reducing the labor supply, are keeping the unemployment rate artificially depressed . Therefore, we need to focus on the change in the number of employed persons . We are already seeing declines in government employment due to structural reforms and shutdowns . Critically, private sector hiring is also expected to slow as companies contend with margin compression and the overall cost environment . Given that employment is likely to deteriorate at a faster pace than the headline inflation rate, I think it’s highly probable the Fed will initiate rate cuts, perhaps as early as December, to preempt a severe downturn . This proactive stance would stabilize short-term rates and, hopefully, long-term rates as well, providing much-needed liquidity .

Will New Liquidity Flow to Financial Assets or Get Stuck in Safety?

If the Fed does start cutting rates—and I project they will cut once in December and continue the cycle into the first half of next year—the next big question is where that new liquidity will go . Traditionally, when central banks ease policy, the money flows into risky financial assets like stocks, creating a rally . However, things are looking non-linear this time around .

One major issue is the massive amount of money currently tied up in the Money Market Funds (MMFs), specifically within the Fed’s Reverse Repo (RRP) facility, which is offering attractive, safe yields . As of Q2, an estimated $7.5 trillion was sitting in MMFs . When the Fed releases new liquidity, a substantial portion of it is likely to be channeled back into these stable, high-yield assets rather than aggressively chasing higher-risk opportunities, especially considering the general psychological fear of high valuations in the current market .

What’s concerning is that we are seeing clear signs of financial system stress, even as the Fed prepares to ease . Indicators like declining bank reserve balances and near-zero RRP balances suggest that the era of "excess liquidity" is drawing to a close . Furthermore, there are worrying signs of credit contraction taking hold, both in the US and globally . Here is a final thought-provoking insight: the current failure of long-term rates to fall is not necessarily a sign of robust economic recovery, as textbooks might suggest. Instead, it could be a precursor to a deep credit squeeze, where high financing costs persist for households and corporations despite rate cuts . This credit contraction, which reduces the total pool of available investment capital, poses a far greater systemic risk factor than even the scale of investment in new AI industries . If this credit squeeze intensifies, it will eventually transmit to the real economy, making the US economic path much bumpier than expected, and further widening the "weight class" gap with other countries.