EY-Parthenon chief economist Gregory Daco outlines why the Fed will gradually cut interest rates and not get too aggressive on “Making Money.”
The Federal Reserve on Tuesday begins a highly anticipated two-day meeting where policymakers are expected to cut interest rates for the first time in four years as stubborn inflation shows signs of continuing to ease.
The Fed’s policymaking arm, the Federal Open Market Committee (FOMC), kicks off its meeting on Tuesday and will announce its decision regarding interest rates on Wednesday, when Fed Chair Jerome Powell will also shed light on the central bank’s thinking at a press conference.
After its last policy meeting in July, the Fed kept its benchmark federal funds rate steady at a 23-year-high range of 5.25% to 5.5% but opened the door to interest rate cuts if inflation continued to ease. Inflation data showed that price growth slowed to 2.9% year over year in July and last week’s release of August data reflected a continuation of that trend, with headline inflation at 2.5% from a year ago.
Powell has signaled that the Fed doesn’t need to wait for inflation to reach the central bank’s target rate of 2%, given the progress in slowing inflation, which peaked at 9.1% in June 2022. Markets expect the Fed to kick off a series of interest rate cuts this week that will continue in the months ahead, though there is debate over the size of the initial rate cut.
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Federal Reserve Chair Jerome Powell signaled last month that the “time has come” for interest rate cuts. (Al Drago/Bloomberg via Getty Images)
A LSEG poll of economists projects the Fed will cut interest rates by 25 basis points this week, lowering the benchmark rate to a range of 5% to 5.25%.
That 25-basis-point cut would be in line with the Fed’s historical preference for smaller initial cuts at the outset of a rate-cutting cycle, as smaller movements give policymakers a greater opportunity to analyze the economic impact ahead of their next meeting.
The most recent time the Fed cut interest rates by 50 basis points to kick off a rate-cutting cycle was in March 2020 as the COVID pandemic began. Prior to that, the Fed opted for 50-basis-point cuts at the onset of rate-cutting cycles in September 2007 amid the housing crisis and in January 2001 when the dot-com bubble burst.
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However, interest rate markets are anticipating a larger cut from the Fed this week. According to the CME FedWatch tool, interest rate traders see a 65% probability of a 50-basis-point cut this week compared to a 35% chance of a 25-basis-point cut.
The Labor Department’s August jobs report came in softer than expected this month, with 142,000 jobs added versus a gain of 160,000 that was anticipated by LSEG economists. An increasingly soft labor market may be contributing to the market’s expectation of a larger interest rate cut by the Fed.
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Markets have fully priced in a 25-basis-point cut, though some traders are anticipating a 50-basis-point cut. (Ting Shen/Bloomberg via Getty Images)
“The Federal Open Market Committee is poised to initiate interest rate cuts at this month’s meeting. Importantly, this rate cut is just the beginning,” Greg McBride, chief financial analyst at Bankrate, said in a statement.
“By itself, one rate cut isn’t a panacea for borrowers grappling with high financing costs and has a minimal impact on the overall household budget. What will be more significant is the cumulative effect of a series of interest rate cuts over time,” McBride added.
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