Federal Reserve Before Interest Rate Decision: Quarter or Half Percent?

This week, an exciting interest rate decision by the Federal Reserve is pending: Will the key interest rate be cut by a classic quarter of a percent or by an unusual half percent? Well, this difference may seem trivial, but it could have significant impacts on the markets. Fed officials face the challenge of balancing between preventing a too rapid cooling of the labor market and decisively combating inflation. A small rate cut could be complemented by larger steps in the coming months. Conversely, a larger cut would indicate that the Fed is more concerned about the rapid cooling of the labor market. By reducing interest rates, credit costs for consumers and businesses are lowered, stimulating the economy. Conversely, rates are increased to dampen excessive growth and reduce inflation. Most of the Fed’s measures are announced well in advance. Therefore, the current uncertainty about how it will act this week is a rarity. Nationwide Chief Economist Kathy Bostjancic describes the situation as a "coin toss." Her concerns mainly relate to the job market, which has cooled but not collapsed. Fed Governor Christopher Waller stated that a marked rise in unemployment would require swift and decisive action. Interestingly, several former Fed officials prefer a larger rate cut. According to the futures markets, the probability of a half-point move is over 65%. As analysts from Goldman Sachs and Barclays emphasize, the increased unemployment rate is more due to the influx of immigrants rather than mass layoffs. Without dramatic economic crises like the 2007-09 recession or the COVID-induced downturn of 2020, there is currently no need for larger rate cuts. Favorable financing conditions support consumers and businesses, and the forecasts for economic performance remain robust. Overall inflation slowed in August, but a core measure surprisingly increased, indicating that inflation has not yet been fully defeated. Therefore, rate cuts could occur more gradually, as noted by Dan North of Allianz Trade North America, to avoid panic. However, there are arguments for a larger rate cut. The subdued job growth and the lowest job openings since January 2021 suggest weaknesses in the labor market. If this leads to a decline in consumer spending, further layoffs could be conceivable, which could derail the Fed's goal of reducing inflation without a recession. Bostjancic argues that inflation is no longer the biggest problem and that the Fed should focus on the weakening labor market. In the long term, the Fed's key interest rate remains at a 23-year high of 5.25% to 5.5%. A gradual lowering could lead to a more stable market situation. However, a dramatic rate step could roil the market. According to Feroli from JPMorgan Chase, lowering the key interest rate before the elections could be perceived as politically motivated, although Fed Chairman Powell has always emphasized that political considerations play no role.