Why the US Federal Reserve may go for a big rate cut this week

The US Federal Reserve faces a crucial decision at its policy-making meeting this week: Ease off slightly on monetary restraint with a 25-basis-point interest-rate cut, or go for a rare 50-basis-point reduction to fend off a recession in America?

What should it do? And what will it do? The answers to these two questions don’t necessarily have to be the same. But this time around, I think they will be.

The tension between 25 or 50 has increased notably, thanks to news articles that have pushed market expectations toward the larger move. As I noted last Friday at a Bretton Woods Committee conference in Singapore, the logic supporting a 50-basis-point cut is compelling.

The two objectives of the US Fed’s dual mandate—price stability and maximum sustainable employment—have come into much closer balance, suggesting that monetary policy should be neutral, neither restraining nor boosting economic activity. Yet, short-term interest rates remain far above neutral. This disparity needs to be corrected as quickly as possible.

Also read: US Fed prepares for first interest rate cut in over four years ahead of 2024 presidential elections

Consider the economic data. The unemployment rate has risen by 0.8 percentage points from its trough in January 2023. In the past three months, payroll employment has increased at the slowest pace since 2020. Wage inflation has moderated to less than 4%, while the Fed’s preferred measure of consumer price inflation is running around 2.5%. 

Although core consumer prices rose a bit more than expected in August, the move was driven by categories that tend to lag (insurance and shelter), and the latest producer price report suggests that the core personal consumption expenditures index will be considerably tamer.

One could even argue that the downside risks to employment outweigh the upside risks to inflation. When the labour market deteriorates beyond a certain point, the process tends to be self-reinforcing. 

Every time the three-month average unemployment rate has risen by more than 0.5 percentage from its low point during the prior 12 months, the ultimate result has been much larger increase—at least 1.9 percentage points—and a recession. 

The threshold might be higher this time, given that the rise in the unemployment rate has been fuelled largely by rapid labour force growth. But this doesn’t invalidate the idea that a tipping point exists, and that the American labour market has either crossed or is approaching it.

A 50-basis-point cut would also fit well with the Fed officials’ next set of economic projections, which they will publish this week. Markets are expecting a total reduction of at least 100 basis points by the end of 2024. 

If the Fed does only 25 now and projects another 50 at its next two meetings this year, it will send a hawkish signal. If it does 25 and projects more than 50, people will wonder why it isn’t cutting more immediately. The larger cut thus helps the Fed get out of this predicament.

Also read: The US Fed is under watch for more than just its policy rate

Why, then, might the Fed not go for 50? Here’s the best explanation that I can come up with.

First, the expected destination for short-term interest rates matters much more than the pace of reductions. Expectations drive longer-term interest rates, including mortgage rates. With roughly 250 basis points of cuts priced in by the end of 2025, the size of this week’s move shouldn’t matter much.

Second, the Fed wants to make sure it has conquered inflation. It has been fooled before: Early this year, inflation bounced back, forcing the central bank to keep rates higher for longer. Fed chair Jerome Powell doesn’t want to repeat the mistakes of Arthur Burns, who didn’t stay the course in pushing down inflation in the 1970s.

Third, although the US economy has slowed a bit and its labour market has clearly weakened, there are few signs that it’s in or near a recession. The Atlanta Fed’s GDPNow model projects annualized, inflation-adjusted growth of 2.5% in the current quarter.

Finally, a smaller move might pre-empt complaints from presidential candidate Donald Trump that the Fed is boosting the economy to improve his rival Kamala Harris’s electoral prospects. Fed officials would presumably prefer to stay out of this year’s election politics as much as possible.

Despite this, I expect the Fed will do 50. I believe Powell favours an aggressive approach: In his speech at Jackson Hole last month, he pointedly observed that a further weakening of the labour market—which seems to be happening—would be “unwelcome.” 

Also read: US Fed rate cut: Will a 25 bps rate cut bring in ’achhe din’ for the Indian stock market?

Monetary policy is tight, when it should be neutral or even easy. And a bigger move now makes it easier for the Fed to align its projections with market expectations, rather than delivering an unpleasant surprise not warranted by the economic outlook. ©bloomberg