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Labor market may need to weaken for Fed to cut: Economist

The Federal Reserve's path on monetary policy remains uncertain, with investors now debating when the central bank will start cutting rates. Santander Chief US Economist Stephen Stanley joins Yahoo Finance to discuss the evolving outlook for Fed rate cuts.

Stanley acknowledges that recent inflation data "is much more stubborn" than the Fed had anticipated, and he expects it to take "most of the year" before the Fed gains enough confidence to embark on a rate-easing cycle. However, Stanley points out "the good news" is that the Fed can afford to be patient because the economy continues to demonstrate resilience, outperforming expectations.

If the economy were to experience a downturn and head into a recession, Stanley cautions that "all bets are off" regarding the Fed's policy path. However, if economic performance remains robust, he expects the prospect of rate cuts to continue being pushed back, reiterating that the Fed may need to see some labor market deterioration before cutting rates.

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance.

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This post was written by Angel Smith

Video transcript

BRAD SMITH: While investors are pushing back rate cut expectations as more Fed officials say, that they don't see any urgency to cut rates any time soon. While traders are expecting that first reduction in September, our next guest believes the Fed will cut rates in November.

Let's bring him in. Stephen Stanley, Santander Chief US economist. Great to have you here with us this morning. So you're looking out even past September at this juncture. Why is that?

STEPHEN STANLEY: I think the inflation data have-- obviously, they've proven to be much more stubborn than I think the Fed had hoped before. And I think that's going to continue to be the case for a while. So I think it's going to be most of the year before the Fed reaches that threshold of greater confidence that Chairman Powell is established for the Fed being able to start rate cutting.

SEANA SMITH: So then what does that mean for equities, Stephen?

STEPHEN STANLEY: Well, I think we've seen a huge adjustment in the markets in terms of the timing and the magnitude of Fed rate cuts for the year. It wasn't so long ago that the markets had over 150 basis points of cuts priced in for the year. And that now is sitting in only 40 basis points.

So I think the bulk of the adjustment in terms of the markets incorporating the idea of the Fed being a little later and less aggressive on rate cuts, hopefully, is behind us, at this point.

The good news is that part of the reason why the Fed is able to be so patient is that the economy has held up well. And we've certainly seen that reflected in corporate earnings quarter after quarter over the last few years. Every quarter, it feels like people are braced for a bad set of profit numbers. And things just seem to always come in better than expected.

The bad news is the Fed isn't going to be cutting rates. But the good news is part of the reason why is because the economy is outperforming expectations.

BRAD SMITH: What type of additional deterioration do you think the Fed would also need to see in the employment situation in order for the thought process of cutting to really emerge and resound among some of the committee members?

STEPHEN STANLEY: Well, certainly, if the economy really starts to head into a period of weakness, maybe, even a recession, then all bets are off. Things change at that point. But assuming that the economy continues to perform OK, that's a really interesting question because the Fed seems to have S tack on that for, probably, about 18 months.

Chairman Powell was consistently saying that the economy was going to need to see a period of subpar growth. We were going to have to have loosening in the labor markets, if the Fed was ever going to get inflation to 2% on a sustainable basis.

And then around the turn of the year, he shifted. And said, well, maybe we can have our cake and eat it too. Maybe inflation will come down without any economic weakening. And that certainly is what the latest round of FOMC economic projections suggests.

So now, it doesn't feel like that rosy scenario is likely to transpire, at least, in the short run. So I still believe that to get to that preferred level on inflation, the Fed is probably going to need to see the labor market weaken a bit. So we'll see how all that plays out. But I think that the Fed has been a little bit too optimistic on that count.