Written by: He Hao, Wall Street News
On Tuesday, Nick Timiraos, a well-known financial journalist known as the "New Fed News Agency," wrote that the Fed is about to cut interest rates, but the magnitude of the first cut remains in doubt. The Fed usually tends to act in a 25 basis point range, but this time, the situation has become complicated.
Timiraos said straight to the point that the current Fed's benchmark interest rate is 5.25%-5.5%, the highest level in 20 years. The Fed is expected to start cutting interest rates on Wednesday this week in order to maintain a stable job market while cooling inflationary pressures.
Timiraos believes that whether the Fed cuts the benchmark interest rate by a larger 50 basis points or the traditional 25 basis points will depend on how Fed Chairman Powell leads his colleagues to make choices amid a series of delicate considerations.
Generally speaking, Fed officials tend to raise or cut interest rates by 25 basis points to study the impact of these measures. But when they believe that their interest rate stance is inconsistent with the balance of risks, they will move faster. For example, in 2022, the Fed raised interest rates by 50 basis points and 75 basis points to respond to high inflation.
Economic data from the United States over the past few months show that inflation has resumed a steady decline toward the Fed's 2% target. But the labor market has cooled, with the unemployment rate rising to 4.2% in August from 3.7% at the end of last year. Monthly nonfarm payroll growth has slowed to an average of 116,000 in the three months to August, compared with 212,000 in December 2023.
Timiraos noted that until late last week, investors were expecting just a 25 basis point rate cut at the Fed's September meeting as few Fed officials had publicly called for further rate cuts.
The quiet period before the Fed's FOMC meeting began on September 7. Timiraos cited speeches by several senior Fed officials, reflecting the officials' hesitation on the extent of the interest rate cut on the eve of this quiet period:
“I strongly advocate for front-loaded rate hikes when inflation accelerates in 2022, and I would also advocate for front-loaded rate cuts if appropriate,” Fed Governor Waller said after the latest nonfarm payrolls report released on September 6. At the time, Waller did not seem to be bothered by the recent slowdown in U.S. job growth. He said that even if job growth fell to 100,000 per month, it would be fine and there was nothing to be afraid of.
Also on September 6, the third-ranking official of the Federal Reserve, New York Fed President Williams, said that recent data show that this is a fairly general trend. What we are seeing are signs of continued cooling. We hope that the economy can balance and remain balanced.
Fed officials often refer to their jobs as risk management — weighing the risk of higher inflation against accelerating unemployment, for example, Timiraos said. They often set interest rates to address the risk that appears more costly. For much of the past two and a half years, as inflation surged above 7%, risk management favored a more aggressive approach to prevent inflation from taking hold.
Thinking from a risk management perspective, Timiraos cites former Dallas Fed President Robert Kaplan:
If officials consider which mistake they would regret least at this week's meeting, it would make sense to start the cycle of rate cuts by 50 basis points.
If I were to go back to where I was, I would say I could live with 25 basis points, but I would prefer 50 basis points. Given where inflation and unemployment are, the Fed's benchmark rate should be about 1 percentage point lower than it is now. If I were starting with a blank slate, I would say it should be around 4.5%.
Because inflation has not yet been fully defeated, the Fed should avoid further economic weakness that would force faster or deeper rate cuts, as this could reignite inflation.
If the Fed cuts rates sharply this week and the economy does well between now and its next meeting in early November, officials are unlikely to regret the big cut because rates will remain relatively high. But if the Fed takes a smaller cut this week and the labor market deteriorates more quickly, officials will regret it more.
The Fed's July minutes showed that some officials were comfortable with a rate cut at the time, but most preferred to wait. The July nonfarm payrolls data released after the Fed's July meeting was much weaker than expected. The Fed was one meeting late, which is manageable, but if they could do it over again, I would have liked them to have cut rates in July. I would rather correct this now and get ahead of the curve than be behind the curve and chase a declining economy throughout the fall.
Timiraos also quoted former Federal Reserve senior adviser William English in the article:
The key question for the Fed at this meeting is how they perceive the balance of risks. If they are more worried about growth and employment than inflation, they will probably want to add a little insurance and cut rates by a larger margin, i.e. 50 basis points.
The arguments for a smaller 25 basis point rate cut include that economic fundamentals are sound, or that cutting rates too quickly could trigger risk-on markets and keep inflation high. If the Fed is not convinced that inflation is really as good as recent data suggests, they may still worry that the fight against inflation will be more protracted and uncomfortable.
A few weeks ago, English said he thought a smaller rate cut would be appropriate. But the recent downward trend in labor market data has made him more nervous, especially because even after two or three rate cuts, interest rates will still be relatively high.
The 50-50 decision this week probably reflects uncertainty among Fed officials about the right choice. It’s not that half the committee is for 50 basis points and the other half is for 25 basis points and they’re fighting each other. It’s that there’s a group of people who are really unsure about the right thing to do here. Ultimately, Powell may reach a reasonable consensus on either one.
Next step
Timiraos said the Fed’s choices will be supplemented by quarterly economic projections that show where officials expect interest rates to be by the end of the year. While those forecasts are not the product of committee discussions, they are just as important to financial markets because Fed policymakers’ rate outlook can affect a range of borrowing costs, including mortgages, auto loans and business debt.
The forecasts for the September meeting are particularly valuable as there are only two meetings left this year, in November and December, and the September forecasts provide an unusually specific view of the two subsequent meetings.
If more officials project a total of 1 percentage point cuts this year, that would mean at least one 50 basis point cut this year. Delaying a bigger cut until later in the year could raise awkward questions about why that’s the best course of action. The alternative is to cut by 25 basis points in September and project the same amount at the final two meetings of the year, leaving open the option to cut faster if the economy deteriorates.
Powell could face dissent from at least one policymaker in a close decision this week. The 12 voting officials include five regional Fed presidents and seven Washington-based Fed governors. No Fed official has dissented from a policy decision in the past two years, tying the longest such streak in the past half century. In addition, no Fed governor has dissented from a rate decision since 2005.
