Will the Fed cut interest rates sharply or slightly? That's a matter of luck.

Big or small?

Will the Federal Reserve cut its benchmark interest rate this week by a typical quarter of a percentage point or a whopping half a percentage point?

The difference between the two possible approaches to the Fed's first rate cut since 2020 may sound trivial. After all, Fed officials are expected to deliver a flurry of rate cuts as inflation and job growth slow significantly, likely boosting the economy and stock prices. As a result, a small cut could be followed by larger cuts in the next few months, and vice versa.

But the Fed's decision at the end of its two-day meeting on Wednesday could move stock and bond markets and reveal whether policymakers are more concerned with extinguishing the last embers of inflation or supporting a labor market that has cooled a little too quickly for most economists' liking.

Will the Fed cut interest rates sharply or slightly? That's a matter of luck.

Why should the Fed lower interest rates?

The central bank cuts interest rates to lower borrowing costs for consumers and businesses, thereby stimulating a weak economy or pulling it out of recession. It raises interest rates – or keeps them high for longer – to dampen growth and reduce inflation.

Since most of the Fed's moves were announced before its meetings, the uncertainty about its actions this week is creating rare drama.

“It’s a coin toss,” said Kathy Bostjancic, chief economist at Nationwide.

What is the situation on the labor market?

For many Fed officials, a weakening labor market has become a greater concern than price increases, which have been steadily slowing in recent months. But the labor market is far from over, the economy has proven to be robust, and Fed officials are wary of declaring victory over inflation too soon after previous disappointments.

Recent data suggest that “the labor market continues to ease but is not deteriorating, and this assessment is important for our upcoming monetary policy decision,” Fed Governor Christopher Waller said in a speech in early September. If the labor market does indeed ease significantly, “the Fed can act quickly and forcefully and adjust its monetary policy.”

Several former Fed policymakers recently told the Wall Street Journal that they favor a deeper rate cut because the Fed's benchmark interest rate is at an all-time high. Futures markets, on the other hand, are giving a probability of over 65 percent that a rate cut of half a percentage point will occur.

Here are several reasons why the Fed might cut its benchmark interest rate by a modest quarter of a percentage point:

Layoffs are still low

Although the unemployment rate has risen sharply – from 3.7 percent in January to a still-low 4.2 percent in August – it is largely due to the influx of immigrants into the workforce rather than mass layoffs, Goldman Sachs and Barclays wrote in notes to clients in recent days. While many of the newly arrived immigrants have not yet found work, that is far less of a concern than a vicious cycle of layoffs that dampens consumer spending and leads to more layoffs. Both research firms expect a quarter-percentage point decline.

There is no economic crisis

Larger interest rate cuts of more than a quarter of a percentage point have been reserved for crises in the past, Goldman Sachs said, such as the Great Recession of 2007-2009 and the Covid-19-induced downturn of 2020. There are currently no such turbulences.

The stock market is booming

Financial conditions are favorable for consumers and businesses, Goldman says. The stock market is near record highs and long-term interest rates have fallen from last year's 16-year highs, depressing borrowing costs. This helps offset the impact of the Fed's high short-term rates on economic activity. Futures markets expect the Fed to cut rates by a total of 1.25 percentage points this year. The Fed could counter a dovish rate cut on Wednesday with forecasts of sharper cuts in the coming months.

An important inflation indicator increased

Although inflation eased overall in August, it rose unexpectedly as rent and other services costs rose, according to the Consumer Price Index, a core indicator that strips out volatile food and energy prices. The message: Inflation is not yet defeated.

The economy is on solid ground

The economy as a whole, particularly consumer spending, “remains very robust and shows little sign of slowing,” Barclays said. The economy grew at a healthy annual rate of 3% in the second quarter. According to S&P Global Market Intelligence, it is on track for a solid 2.3% increase in the current quarter.

A sharp cut could shake the markets

Fed officials have said they prefer to cut rates gradually to gauge the impact on the economy. A deeper Fed rate cut could “send a panic message” and “spook the markets,” Dan North, senior economist at Allianz Trade North America, told MarketWatch this week.

It is an election year

A half-percentage point cut in interest rates just before the presidential election could be seen as strengthening the economy and thus also as support for Democratic Vice President Kamala Harris, said economist Michael Feroli of JPMorgan Chase. However, Feroli also noted that Powell had said that politics plays no role in the Fed's decisions.

“We believe Powell,” he said.

Here are reasons why the Fed might cut interest rates by half a percentage point:

The labor market is weakening

Job growth slowed dramatically from June to August, now averaging 116,000 per month, compared with 211,000 in the previous three months. Although Hurricane Beryl wiped out July's wage gains, August was supposed to have brought a larger rebound.

Meanwhile, job openings have fallen to their lowest level since January 2021 and hiring has slowed to a pace last seen in early 2018. While layoffs have remained low, a rising unemployment rate and weak hiring mean it takes longer for unemployed workers to find a job. That could prompt them to cut spending, which in turn could lead companies to further reduce hiring or lay off more, says economist Nancy Vanden Houten of Oxford Economics.

Such a scenario could jeopardize the Fed's goal of achieving the rare feat of containing inflation without plunging the economy into recession.

Inflation has fallen close to the Fed's target

In contrast, the Fed's preferred annual inflation measure was 2.6% last month, down from 5.6% in mid-2022 and not far above its 2% target. In other words, inflation is no longer the Fed's biggest concern and officials should focus on the weakening labor market, Bostjancic says.

The Fed’s key interest rate is too high

After sharp rate hikes in 2022 and 2023 to combat inflation, the Fed's benchmark interest rate remains at a 23-year high of 5.25 to 5.5 percent. Since Powell has described the risks to the Fed's goals of stable prices and maximum employment as balanced, the benchmark interest rate should ideally be at a “neutral” level of just under 4 percent, Bostjancic says. That's a rate that would neither boost nor slow the economy.

Will the Fed cut interest rates sharply or slightly? That's a matter of luck.

Why should the Fed lower interest rates?

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