An excessive and totally unnecessary U.S. interest rate cut last September has stored a problem of price instability for the next American government facing a runaway public debt, huge budget deficits and unprecedented challenges to world peace and security.

The Fed’s procyclical move is a major policy error. A credit easing of the magnitude usually applied in cases of sharp business downturns is manifestly inappropriate in a fully employed economy running at twice the pace set by its physical limits to growth.

When the policy interest rate (i.e., the federal funds rate) was cut by 50 basis points on September 18 to the range of 4.75% - 5.0%, the U.S. unemployment rate was 4.2%, and 235 thousand new jobs were created during the previous three months. The total U.S. employment last August was roughly identical to its year earlier level.

In view of those numbers, the Fed’s alleged anxiety about American jobs was entirely unjustified, especially since the actual unemployment rate of 4.2% was safely below the estimated U.S. full employment unemployment rate of 4.5% to 5.5%.

Wall Street buyer’s remorse?

Those strong labor market numbers were generated in an economy running in the first half of this year at an annual rate of 3%, almost double the 1.6% potential and noninflationary growth rate, based on U.S. data for productivity and labor supply.

The Fed was also aware of the fact that the economy was driven by a hugely expansionary fiscal policy, with budget deficits of 8% of GDP, public debt of $35 trillion, and the government spending growing at an average quarterly rate of 4% in the twelve months to June 2024.

Under those circumstances, a large interest rate cut just rounded off an inflationary policy mix.

Wall Street traders – expecting only a 25-basis point cut – promptly cashed in the windfall of the Fed’s extra bonus of another 25 basis points, while trying to figure out why the Fed “went big.”

Such a Wall Street “puzzle” in an election year is the ultimate irony.

At any rate, answers came faster than expected.

A day after the Fed announced its interest rate cut, the news was published that the number of Americans applying for unemployment benefits fell to their lowest level in four months. That was followed by a report that the total U.S. nonfarm jobs increased during September by 254,000, exceeding the average monthly gain of 203,000 over the previous 12 months.

Predictably, that strong labor demand continued to push the jobless rate down to 4.1% in September from its recent peak of 4.3% in July.

And then, the authoritative ISM business survey was published on October 3, 2024, showing that the expansion of the U.S. service sector (about 90% of the economy) reached the highest level since February 2023, with literally booming business activity and new orders.

Economic crisis and widening regional wars

Labor markets thus entered the early holiday season on a high note, with plentiful jobs and wages growing by 4%.

Inflation for August, measured by the consumer price index, came in deceptively tame at 2.5%, but its core segment (excluding energy and food prices) stood at 3.2% and, more importantly, its core service price component reached 4.9%.

Service sector prices rising at such a high rate in a predominantly service-driven economy is a serious issue because it is an area of activity where demand-supply adjustments are hindered by weak competition and regulatory rigidities.

As things now stand, the probability is very high that a traditionally strong consumer demand during the year-end holidays will keep inflation accelerating, especially if, as seems certain, the Middle East war continues to expand – triggering rising energy and food prices.

The price of oil has gone up 8% since Iran attacked Israel on October 1, 2024, with 200 ballistic missiles. Israel is now preparing a revenge that will apparently target energy installations in a country that has the third-largest oil reserves in the world. Last year, Iran produced 4 million bpd (barrels per day) – with more than a third of that oil output shipped to China.

The U.S. is a large energy and food producer, but it will be impossible to completely insulate the domestic market from crisis-driven price increases of such essential products.

The situation we have here is that the Fed has set the stage for an inflationary takeoff.

Facing an economic crisis of high inflation, soaring public debt and excessive budget deficits, the new government will have to implement a tightening policy mix in some combination of higher credit costs, spending cuts and tax increases.

That clearly is a recession scenario at the worst possible time when Washington will have to deal with widening wars in Europe and the Middle East, growing hostilities in Southeast Asia and an increasingly precarious armistice on the Korean Peninsula.