The Federal Reserve has indicated only one interest rate cut this year, but recent economic data has some economists questioning if that move will come soon enough. While retail sales have slowed and inflation has cooled, signs of a softening labor market are emerging, presenting the Fed with a delicate balancing act between its dual mandates of price stability and maximum employment.

May’s economic data painted a picture of a cooling economy. Retail sales growth slowed compared to last year, and inflation eased to its lowest pace since July 2022. Economists predict that the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) index, also slowed in May.

Despite a better-than-expected May jobs report, the unemployment rate ticked up to 4%, its highest level in over a year. Citi’s Economic Surprise Index, a measure of how data outperforms forecasts, is near a one-year low. This suggests that the economic momentum may be waning.

Some economists, like Renaissance Macro’s Neil Dutta, argue that the Fed should initiate rate cuts sooner rather than later to support the labor market. Dutta points out that the job openings rate has returned to pre-pandemic levels, and any further decline could trigger a rise in unemployment.

The economics team at Goldman Sachs shares Dutta’s concerns. Historically, a decline in the job openings rate is often followed by an increase in unemployment. They worry that the Fed, in its efforts to tame inflation, might unintentionally weaken labor demand too much.

Balancing Act

Federal Reserve Chair Jerome Powell has acknowledged the gradual cooling of the labor market but hasn’t seen signs of significant weakness yet. However, economists like Dutta and the Goldman Sachs team are more concerned about where the data is headed than where it stands currently. They fear that waiting too long to cut rates could lead to a deeper economic slowdown.

So far, investors have taken the Fed’s outlook in stride, with the S&P 500 and Nasdaq Composite hitting record highs. Some equity strategists have even raised their year-end outlooks for the S&P 500.

However, Citi US equity strategist Scott Chronert cautions that investors should watch for signs of the Fed’s rate hikes impacting corporate earnings and overall economic activity.

Some worry that the Fed, in its cautious approach to inflation, might wait too long to cut rates, harming the economy. Mohamed El-Erian, Allianz’s chief economic adviser, warns that small businesses and lower-income households, already struggling with higher rates, could bear the brunt of the delay.

The Fed faces a difficult choice as economic data cools and the labor market softens. While inflation is easing, waiting too long to cut rates could risk a more severe economic slowdown and hurt vulnerable segments of the population. The Fed’s delicate balancing act will be closely watched by investors and economists alike in the coming months.