Even with persistent high inflation and a robust job market, the Federal Reserve is anticipated to cut interest rates this week for the third consecutive meeting.

What’s behind this decision?

Some economic experts warn that the Fed’s actions might be misguided, potentially sparking renewed inflation and undermining their commitment to base decisions on the most recent economic data.

“I believe that a rate cut next week would be a mistake because (a) it is not justified and could lead to increased inflation, and (b) it may damage the Fed’s credibility,” stated Bernard Baumohl, chief global economist at the Economic Outlook Group, in a message to clients.

Conversely, some analysts suggest that the inflation figures, despite appearing concerning, indicate a downward trend, and the Fed should continue its methodical approach to return rates to more standard levels.

Who Stands to Gain from Fed Rate Cuts?

The Federal Reserve typically raises rates to combat inflation by making loans more expensive, which cools spending and investment. Conversely, it reduces rates to stimulate the economy and job creation or to send rates back to a neutral level that neither promotes nor hinders growth as inflation decreases. Lower rates generally help boost stock market performance.

Is Another Rate Cut Imminent?

Futures markets predict a 97% likelihood that the Fed will decrease its key short-term rate by another quarter point on Wednesday after a two-day policy meeting, but they expect a pause in January and a slowing of cuts next year to just two quarter-point reductions. This is half of the four cuts anticipated by Fed officials last September and aligns with their recent statements about taking a more cautious approach in 2025 to evaluate the impacts, particularly given the economy’s solid performance.

Why Did the Fed Raise Interest Rates?

In 2022 and 2023, the central bank increased its primary rate from near zero to a range between 5.25% and 5.5% to curb a spike in prices caused by the pandemic that pushed annual inflation to a 40-year peak of 9.1%.

Inflation has dropped to below 3% this year, nearing the Fed’s target of 2%, which has prompted officials to reduce the benchmark rate by 0.75 percentage points since September.

Current Inflation Rate

However, average price increases have remained high recently. According to the Labor Department, overall inflation rose to 2.7% in November for the second consecutive month. Core prices—excluding volatile food and energy items that the Fed monitors more carefully—have also surged sharply for the fourth month in a row, keeping annual core inflation steady at 3.3%.

These core price shifts are more sustainable because they depend on consumer demand, which the Fed can influence through interest rates, rather than global commodity prices.

Wholesale costs, which generally influence consumer prices, also saw a significant increase of 0.4% last month, largely driven by a spike in egg prices due to bird flu outbreaks.

Current Economic Conditions

Meanwhile, the economy has shown resilience despite high inflation and interest rates that particularly impact lower-income households. The economy grew at a robust annual rate of 2.8% in the third quarter, with the Federal Reserve Bank of Atlanta projecting a 3.3% increase for the current quarter.

Job growth rebounded significantly in November after setbacks caused by hurricanes and strikes, with an addition of 227,000 jobs.

In a recent address, Fed Governor Christopher Waller indicated he favored a rate decrease in December, but emphasized that the final decision would rely on subsequent reports. Those findings, which have since been released, show inflation and the job market have exceeded projections.

So why does the Fed still intend to reduce rates this week?

Aiming for a Normal Interest Rate

Fed officials have voiced that the current key rate is excessively high and are working to gradually bring it down to a neutral level of approximately 3%. The present rate stands between 4.5% to 4.75%.

Waller mentioned that the rate still poses “significant restrictions” considering the current reductions in inflation, implying it could be unnecessarily constraining economic growth. “Reducing the rate again,” he noted, “would simply mean we’re not applying as much pressure on the brakes.”

Barclays economist Marc Giannoni suggested that the Fed aims to nudge the rate closer to neutral as soon as possible to prevent further economic hindrance, reducing the risk of a recession. After a total of one percentage point of cuts in January, officials could then pause to evaluate their effects, he added.

Impact of Trump’s Tariffs

Fed Chair Jerome Powell may wish to implement one more quarter-point cut prior to President-elect Trump following through on his threats to impose tariffs on imports from Canada, Mexico, and China as early as his first day in office, which are expected to escalate inflation, according to Baumohl. Such tariffs could compel the Fed to maintain steady rates or decrease them more gradually than initially planned.

Officials have not yet incorporated the unpredictability of Trump’s trade policies into their decision-making. Giannoni anticipates that tariffs could lead to an increase in inflation, but this effect is expected to manifest only in the latter half of the year.

Inflation is slowing down

While overall inflation has risen, the specifics are looking more favorable for Federal Reserve officials who desire a reduction.

Rent, the largest single factor contributing to inflation, saw a minimal rise of just 0.2% in November, marking the smallest monthly increase since July 2021.

Other consistent drivers of inflation, such as auto repair costs and car insurance, also showed slight increases this November. The overall decrease in service-related inflation is “encouraging for the Fed,” according to Kathy Bostjancic, Chief Economist at Nationwide.

Simultaneously, some prices that spiked last month – notably hotel prices and car costs – are seen as unstable, noted Samuel Tombs, Chief U.S. Economist at Pantheon Macroeconomics. In other words, these prices are likely to stabilize soon. The rise in prices for new and used cars was partly driven by increased demand following two hurricanes in the Southeast that damaged a large number of vehicles early in the fall, leading to a surge in replacements, Tombs explained.

A softer inflation measure

Despite the recent volatility in the consumer price index, another inflation metric closely monitored by the Fed – the personal consumption expenditures (PCE) index – is anticipated to report lower cost increases.

Next week’s report is expected to show that the PCE index rose by only 0.1% month-over-month in November, according to Barclays. Many items that heavily influence the CPI, including cars and hotel costs, carry less weight in the PCE measure, according to Tombs.

Cooling labor market trends

Although job growth remains strong, signs indicate the labor market is cooling. The unemployment rate increased from 4.1% to 4.2% last month, as noted by Barclays. Additionally, the average annual wage growth has stabilized at 4%, down from 5.9% early in 2022. Increased productivity – defined as output per worker – means companies can offer substantial raises without needing to raise prices, according to Oxford Economics.

More cautious predictions for interest rates

On Wednesday, Fed officials are expected to indicate that only two or three rate cuts are likely next year, according to Barclays.

This kind of prediction could influence the public’s expectations for inflation, which in turn affects actual inflation, Giannoni noted. A lower estimate of rate cuts may convey a more cautious approach, somewhat dampening the impact of a potential rate cut.

Expectations of a rate cut in futures markets

Futures markets, which speculate on the Fed’s interest rate directions, along with stock market activity, suggest that a rate cut is almost inevitable this Wednesday. If the inflation data from last week led officials to reconsider their stance, they likely couldn’t express those sentiments publicly.

Though Fed officials insist that market movements do not influence their decisions, economists believe the central bank prefers to avoid unsettling investors. “They aim to avoid contradicting market expectations,” Giannoni stated.