Significant or minimal?

Is the Federal Reserve set to decrease its primary interest rate by the usual quarter-point this week, or will it opt for a more substantial half-point cut?

The potential differences between these two strategies for the first Fed rate reduction since 2020 might seem minor. However, given the recent slowdown in inflation and job growth, Fed officials are anticipated to initiate a series of rate cuts, potentially stimulating the economy and boosting stock markets. Thus, a slight decrease might lead to larger reductions shortly after, or the opposite could occur.

The decision made at the conclusion of a two-day meeting on Wednesday could significantly impact stock and bond markets and indicate whether officials are more focused on extinguishing the last remnants of inflation or supporting a labor market that appears to be cooling off too quickly for many economists’ liking.

Why Might the Fed Lower Interest Rates?

The central bank lowers interest rates to decrease borrowing costs for consumers and businesses, either to revitalize a struggling economy or to help it recover from a recession. Conversely, it raises rates—maintaining them at higher levels for extended periods—to slow economic growth and decrease inflation.

While the Federal Reserve’s actions are typically well-communicated prior to meetings, the uncertainty surrounding this week’s decision adds an element of suspense.

“It’s like flipping a coin,” stated Nationwide Chief Economist Kathy Bostjancic.

What About the Job Market?

Several Fed officials are now more concerned about a declining labor market than persistent price hikes that have shown signs of slowing in recent months. However, the job market remains stable, the economy is resilient, and Fed officials are cautious about declaring an end to inflation too soon due to past disappointments.

Recent statistics indicate that “the labor market is softening but not collapsing, and this assessment is critical for our forthcoming monetary policy decisions,” stated Fed Governor Christopher Waller in a speech earlier this month. He noted that if the job market significantly deteriorates, the Fed “can respond swiftly and decisively with adjustments to monetary policy.”

Nevertheless, with the Fed’s key rate at a high historical level, several former Fed policymakers expressed their preference for a more significant rate cut in recent comments to the Wall Street Journal. As a result, futures markets assign a greater than 65% probability to a half-point cut.

Reasons the Fed May Opt for a Mild Quarter-Point Cut:

Low Layoff Rates

Even though the unemployment rate has seen an increase—rising from 3.7% in January to a still-manageable 4.2% in August—it primarily results from an influx of immigrants joining the workforce and not because of extensive layoffs, as noted by Goldman Sachs and Barclays in recent reports. Many of these new immigrants are still seeking jobs, which is less concerning than a cycle of layoffs that could lead to reduced consumer spending and further layoffs. Both research firms anticipate a quarter-point reduction.

Absence of Economic Crisis

Historically, more substantial rate cuts beyond a quarter point are enacted during economic crises, according to Goldman Sachs, citing examples like the Great Recession of 2007-09 and the 2020 downturn caused by COVID-19. Currently, there is no such crisis at play.

Stock Market Strength

According to Goldman Sachs, financial conditions are favorable for consumers and businesses. The stock market hovers near all-time highs, and long-term interest rates have decreased from last year’s 16-year peaks, which has eased borrowing costs. This situation helps mitigate the impact of the Fed’s elevated short-term rates on overall economic activity. Futures markets predict that the Fed will reduce rates by a total of 1.25 percentage points this year, potentially counterbalancing a modest rate cut on Wednesday with anticipations of more significant reductions in the coming months.

Increment in Key Inflation Measure

While overall inflation decreased in August, a core metric—excluding volatile food and energy prices—unexpectedly picked up, reflecting advances in rent and other service costs according to the consumer price index. This underscores the fact that inflation is not fully under control yet.

Stable Economic Conditions

Overall, the economy—especially consumer spending—remains very robust and shows little indication of slowing down, as noted by Barclays. The economy grew at a solid 3% annualized rate in the second quarter and is on course for a notable 2.3% increase this quarter, based on data from S&P Global Market Intelligence.

Concerns Over Market Reaction to Major Cuts

Officials from the Fed prefer to approach interest rate reductions gradually to better assess their impact on the economy. A significant cut could “create an impression of panic” and potentially “disturb the markets,” warned Dan North, a senior economist at Allianz Trade North America, in a recent statement to MarketWatch.

Political Climate in an Election Year

A half-point rate cut right before the presidential election might be perceived as a move to boost the economy, potentially benefiting Vice President Kamala Harris, the Democratic nominee, according to economist Michael Feroli from JPMorgan Chase. However, Feroli emphasizes that Powell has maintained that political considerations do not influence Fed decisions.

“We trust Powell,” he affirmed.

Reasons the Fed Might Implement a Significant Half-Point Cut:

Key Point:

Job Market Showing Signs of Weakness

The rate of job creation has significantly decreased, averaging only 116,000 new jobs monthly from June to August, a drop from 211,000 in the prior three months. Although Hurricane Beryl affected job gains in July, a more substantial recovery in August was expected.

In addition, job openings have reached their lowest point since January 2021, and hiring has slowed to levels not seen since early 2018. While layoffs have stayed low, an increasing unemployment rate coupled with weak hiring makes it harder for unemployed individuals to find new jobs. This situation could lead them to reduce their spending, further prompting businesses to cut back on hiring or increase layoffs, according to economist Nancy Vanden Houten from Oxford Economics.

This situation could threaten the Federal Reserve’s goal of controlling inflation without causing a recession.

Inflation Rates Approaching Fed’s Target

On a positive note, the Federal Reserve’s favorite measure of annual inflation stood at 2.6% last month, a decrease from 5.6% in mid-2022, and it is now close to the 2% target. This indicates that inflation is no longer the main issue for the Fed, and officials should concentrate on the struggling labor market, as noted by Bostjancic.

Fed’s Interest Rates Too Elevated

Following aggressive interest rate hikes in 2022 and 2023 to combat inflation, the Fed’s benchmark rate currently sits at a 23-year high of between 5.25% and 5.5%. Powell has characterized the risks to maintaining stable prices and high employment as balanced, suggesting that the ideal benchmark rate should be around 4%, which is considered “neutral” — neither promoting nor hindering economic growth, according to Bostjancic.

“The noticeable decline in the job market doesn’t align with such a restrictive policy rate,” stated Bostjancic.

If the Fed were to lower rates by a quarter point at each meeting, it would take nearly a year to reach the neutral rate, according to Feroli’s note to clients. This suggests that a quicker series of rate cuts would be advisable, he mentioned.

Nervous Stock and Bond Markets

Since the futures markets now anticipate more than a percentage point of rate reductions this year, Bostjancic believes that a half-point cut would not unsettle investors. However, she argues that a quarter-point cut could disrupt stock and bond markets, potentially destabilizing the economy and the job market.

“The bond markets could react negatively,” she warned.