That the Fed will cut rates at its meeting next week is all but settled. But how much is shaping up to be a close call.
Jerome Powell, chair of the Federal Reserve, at a news conference in July.
Federal Reserve Chair Jerome Powell faces a difficult decision as the central bank prepares to cut interest rates next week: Start small or begin big?
The central bank is set to reduce rates for the first time since 2020 at its meeting on Sept. 17-18. Because officials have signaled greater confidence that they can make multiple rate cuts over the next several months, they are confronting questions over whether to cut by a traditional 0.25 percentage point or by a larger 0.5 point.
Powell kept all his options on the table in a speech last month in Jackson Hole, Wyo., that surprised some of his colleagues with its unambiguous call to turn attention to incipient risks in the jobs market. “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks,” he said then.
Officials last year raised their benchmark rate to around 5.3%, a two-decade high, and will have held it at that level for the last 14 months to combat inflation, which has declined notably.
Several analysts said firmer housing costs in the consumer-price index report Wednesday weakened the case to push through a larger cut next week.
They are nervous about keeping interest rates too high for too long amid evidence that higher borrowing costs are working as intended to slow inflation by cooling spending, investment and hiring. They don’t want to let slip through their grasp a soft landing, in which inflation falls without a serious jump in joblessness.
Answers to the tactical question over how fast to go could reveal clues about the Fed’s broader strategy. The amount of cuts over the next few months “is going to be a lot more important than whether the first move is 25 or 50, which I think is a close call,” said Jon Faust, who served until earlier this year as a senior adviser to Powell.
Recent economic data have been mixed. Several analysts said firmer housing costs in the consumer-price index report Wednesday weakened the case to push through a larger cut next week, sending market expectations of a smaller cut to around 85%, according to CME Group. But a separate report Thursday signaled that underlying prices in the Fed’s preferred inflation gauge were likely to have been considerably milder in August, keeping the door open for the Fed to focus on preventing labor-market softening.
Meanwhile, hiring in June and July was weaker than initially reported, but payroll growth improved in August. Layoffs have been low. Claims for jobless benefits last week stood at roughly the same low level of one year ago, the Labor Department said Thursday.
Quarterly economic projections to be released at next week’s meeting could further complicate matters. Those projections will show how many rate cuts officials expect this year. The Fed has three meetings remaining this year: next week, and in November and December.
Those projections aren’t the product of a committee debate but could be as important to investors as the size of the rate reduction, especially if officials opt for the smaller cut. Because markets expect the Fed to cut rates by more than 100 basis points this year, projections that show fewer cuts risk a market pullback that tightens financial conditions, sending up borrowing costs at the very moment the Fed is reducing short-term rates.
The Fed normally prefers to move in increments of 0.25 point, or 25 basis points, because smaller adjustments give them more time to study the effect of their policy changes. Some officials have suggested they would rather speed up the pace once the economy looks like it is weakening further.
Alternatively, officials could conclude that if they expect a 50-basis-point move is likely in November or December, they ought to make that move now, when rates are farthest from their ultimate destination.
The case for starting smaller presumes the economy is fundamentally fine, according to current and former officials. They say starting with a 50-basis-point cut could communicate greater alarm about the economy or lead markets to anticipate a faster pace of rate cuts, which in turn might ignite market rallies that make it harder to finish the inflation fight.
A related worry: A larger cut would lead markets to mistakenly assume the Fed plans to cut rates by the same amount at meetings in November and December. It “will set up an expectation that they would go very rapidly” to a neutral level of interest rates designed to neither spur nor slow growth, said James Bullard, who was president of the St. Louis Fed from 2008 to 2023, in an interview last week.
Given the Fed’s preference to build a broad consensus and the challenge of explaining a larger rate cut right before the election, starting with a 0.25-point cut offers the path of least resistance. “25 is easy at the start,” said Esther George, who was Kansas City Fed president from 2011 until 2023. “You could say, ‘We can either keep this up for a while, or if it looks like things are weaker, we can go harder.’”
The case for starting with a larger cut centers on taking out insurance against the risk the economy will slow down more under the weight of past increases at a time when officials no longer think such a slowdown is necessary to complete the job of bringing inflation back to their 2% goal.
With inflation cooling as the Fed holds nominal rates steady, inflation-adjusted or real rates are as high as they have been since the central bank started hiking rates.
Officials need to consider whether “you want to be the most restrictive you’ve been in the entire rate-tightening cycle at a moment when there’s a pretty clear path to 2% inflation and the unemployment rate is above” where most Fed officials expected it would go this year, said Chicago Fed President Austan Goolsbee in an interview last week.
The rate-setting Federal Open Market Committee has usually cut in larger increments when financial markets are showing greater alarm over the economic outlook, as was the case at the start of 2001 and in 2007 during the early innings of the global financial crises.
“I don’t think we’re in a spot that really shouts out for a pre-emptive 50,” said Faust, a fellow at the Center for Financial Economics at Johns Hopkins University. “But my preference would be slightly toward starting with 50. And I still think there’s a reasonable chance that the FOMC might get there as well.”
Faust said he thinks the Fed could manage concerns about spooking investors with a larger cut by providing “a lot of language around it that makes it not scary.” He added, “It wouldn’t need to be a sign of worry.”
Fed Chair Jerome Powell, left with Tiff Macklem, center, governor of the Bank of Canada, and Andrew Bailey, governor of the Bank of England at the Jackson Hole Economic Policy Symposium in August.
Faust said he thinks several officials will project 100 basis points in cuts this year. If that is the case, leading off with a 25-basis-point cut risks raising awkward questions over why officials expect to deliver a larger rate cut later this year but didn’t lead with it.
If the risks are truly balanced between higher inflation and weaker labor market conditions, as Fed officials have said they believe is the case, then the Fed should want rates much closer to a neutral level, said William Dudley, who served as New York Fed president from 2009 to 2018. Given that all Fed officials believe that rate is below 4%, it doesn’t make sense to move in 25-basis-point increments. “Logic says they should be going faster,” he said.
For those reasons, George said she would find it hard to oppose a larger cut right now. “You can make a very good case for 50, to say, ‘Just as we went quickly’” to raise rates above a neutral setting, “we’re now well above it, and so we can take a couple of bites at this apple.”
Last week’s jobs report wasn’t particularly reassuring, said Dudley, because the unemployment rate has climbed by 0.5 percentage point since the start of the year. Normally, when the unemployment rate rises by a little bit, it tends to continue rising—and by a lot.
The housing market has been soft in recent months, and while the construction sector added jobs in August, declines in new residential construction point to another source of potential weakness ahead for hiring.
Businesses and financial companies that cater to low- and middle-income consumers are pointing to signs of greater strain, and the personal savings rate fell to 2.9% in July, near its lowest level since 2007.
While the economy has been growing at a reasonably solid pace this year, “we have supported this growth by doing less and less saving, and more and more borrowing. That’s not sustainable,” said Donald Kohn, a former Fed vice chair.
“We are at a point where you might say, ‘I could go either way—25 or 50,’ but I think the risk management has shifted to the labor market and favors doing 50,” he said.