This week, the Federal Reserve faces a crucial decision: will it opt for a standard quarter-point cut in its key interest rate, or will it take a more aggressive approach with a half-point reduction? While the difference may seem minor, the implications for the economy, stock markets, and inflation control are significant.
With inflation cooling and job growth slowing, the Fed is expected to begin a series of rate cuts. A smaller reduction could lead to larger cuts in the months ahead, and a bigger cut now might signal a more cautious approach going forward.
At the conclusion of the Fed’s two-day meeting, the decision will reflect whether officials prioritize fully extinguishing inflation or supporting a labor market that has started to cool more rapidly than expected.
Why the Fed Might Lower Rates
When the economy weakens or risks sliding into recession, the Fed cuts rates to lower borrowing costs for consumers and businesses, spurring economic activity. On the other hand, it raises or holds rates steady to keep inflation in check.
Unlike many past meetings where the Fed’s decisions were fairly predictable, this week’s uncertainty has added a level of suspense to the proceedings. As Nationwide Chief Economist Kathy Bostjancic puts it, “It is a coin toss.”
Labor Market Concerns
For many Fed officials, the softening labor market is becoming a greater concern than inflation, which has been steadily easing. Still, the job market remains resilient, and some worry that declaring victory over inflation could be premature.
Christopher Waller, a Fed Governor, noted recently that the labor market is “softening but not deteriorating.” Should job conditions worsen significantly, the Fed could “act quickly and forcefully to adjust monetary policy.”
Some economists, however, see the high benchmark rate as a reason for a larger cut. With futures markets anticipating a 65% chance of a half-point reduction, the possibility of a bigger move looms.
Is the Economy in Crisis?
Historically, large rate cuts have been reserved for times of economic crisis, such as the 2008 Great Recession or the 2020 COVID-19 downturn. Today, the economy is far from crisis mode, with unemployment remaining low and no widespread layoffs.
While the unemployment rate has risen from 3.7% in January to 4.2% in August, much of that increase is attributed to an influx of new workers rather than job cuts. This suggests the situation isn’t dire enough to warrant a more aggressive cut.
Financial Markets are Strong
The stock market is near all-time highs, and long-term interest rates have come down from the peaks reached last year, reducing borrowing costs. Given the relatively stable economic conditions, some analysts believe that the Fed could afford a measured approach, with a quarter-point cut and the potential for more cuts later this year.
Inflation Still Lingers
Although inflation has eased overall, a core measure that excludes food and energy saw a slight uptick in August. This suggests inflation isn’t entirely under control, which could prompt caution from the Fed.
Gradual Rate Cuts Preferred
Fed officials have often emphasized their preference for gradual rate cuts, which allow them to evaluate the economy’s response over time. A significant cut could send an unintended signal of panic, which might unsettle markets, says Dan North, senior economist at Allianz Trade.
Election Year Dynamics
The timing of a large rate cut could raise questions about political motivations in an election year. Cutting rates sharply just before a presidential election could be seen as boosting the economy, which might benefit Vice President Kamala Harris, the Democratic nominee. Yet, Fed Chair Jerome Powell has repeatedly asserted that the Fed’s decisions are insulated from politics.
Mixed Signals for the Job Market
Job growth has slowed, with fewer monthly gains compared to earlier in the year. This suggests the job market is softening, but not deteriorating at a dangerous pace. Job openings are down, and hiring is slower, which could signal further economic cooling.
Inflation Near Fed’s Target
Inflation has fallen to 2.6%, not far from the Fed’s 2% goal. This shift means inflation is no longer the central worry for many policymakers, who may now focus more on bolstering the labor market.
Current Rates are Restrictive
With the Fed’s key rate at a 23-year high of 5.25% to 5.5%, some economists argue that it’s overly restrictive given the current balance of risks to inflation and employment. Bostjancic contends that the Fed should move faster toward a “neutral” rate closer to 4%, which would neither stimulate nor dampen growth.
Stock and Bond Market Volatility
Futures markets are expecting over a percentage point in cuts this year, and some analysts argue that a smaller quarter-point cut could actually cause more market turbulence. Investors may prefer a more decisive move to reassure markets, especially as uncertainties about inflation and job growth persist.
Ultimately, the Fed’s decision this week could set the tone for the months ahead, shaping not only economic policy but also market sentiment.
