As we all know, the Federal Reserve is getting ready to drop interest rates next week for the first time in what feels like ages. But perhaps don’t expect any big fireworks to come out of it.

The easing cycle is predicted to be “mild” compared to the Fed’s historical standards. This comes straight from economists at ratings agency, Fitch, who expect a 25-basis-point cut first, followed by another 25-basis-point cut in December. 

Headquarters of the Federal Reserve in Washington, D.C.

The pace stays slow but steady, with more cuts planned in the next couple of years: 125 basis points in 2025 and 75 basis points in 2026. If you’re adding that up, that’s a total of 250 basis points spread across ten cuts over 25 months. 

Compare that to earlier cycles, where the median drop from peak to bottom was 470 basis points. This time, though, it seems the Fed is being extra cautious.

Inflation isn’t quite dead yet

So, why the slow walk on rate cuts? Inflation of course.

The Fed has been wrestling inflation for years now, and even though it’s cooled down, it’s still not where they want it to be. The consumer price index (CPI) is still above the Fed’s target of 2%.

Fitch pointed out that the drop in core inflation— which leaves out volatile prices like food and energy—was mostly thanks to falling auto prices. But those prices might not stay low for long.

US president Joe Biden and VP Kamala Harris

According to a Labor Department report, inflation in the US hit its lowest level since February 2021. In August, the CPI went up by 2.5% year on year, just below the 2.6% expected by Dow Jones. 

Month over month, inflation rose by 0.2% from July. Core CPI came in at 3.2% over the last 12 months, holding steady with earlier forecasts, while the month-to-month core inflation ticked up by 0.3%, slightly higher than the expected 0.2%.

Powell is wary

The inflation challenges Jerome Powell and his team faced for more than three years have left scars. They’re still trying to figure out what really drives it, as central banks’ understanding has been revealed to be full of gaps.

It took them way longer to get inflation under control than anyone expected, and now Powell is wary of making the same mistakes again. That caution can be heard from the economists too. 

Krishna Guha, vice-chair of Evercore ISI, noted that a half-point cut next week “would take less risk with the soft landing.” 

Jerome Powell

Meanwhile, Donald Kohn, former vice-chair at the Fed, told us that even if the Fed starts slow, they could quickly adjust policy if inflation starts acting up again.

They did the same thing back in 2022 when inflation was a bigger beast than anyone anticipated.

Christopher Waller, a Fed governor, said he’s keeping an open mind about the cuts’ pace, saying that bigger cuts might be on the table if the data points in that direction. 

John Williams, president of the New York Fed, admitted he’s undecided on just how much they should cut, but he’s confident they’re in a good position to hit their goals.

What about a half-point cut?

There’s been chatter about a more aggressive cut of 50 basis points. But that would probably do the opposite of what’s intended. It would also signal that the Fed is more worried about the economy than they’re letting on.

Loretta Mester, who recently retired as Cleveland’s Fed president, also chimed in on the half-point debate, saying that even though it’s an option, the messaging around such a move would be tricky.

According to her, there’s no “compelling reason” to go that route just yet. Instead, a gradual approach seems to be the safer bet.

Of course, a bigger-than-expected cut could also cause political backlash. Donald Trump has already warned the Fed against making any cuts in September, especially with the election just weeks away.

Donald Trump

If he wins, he’s going to fire Powell and the White House will be in charge of the Federal Reserve, just like he wants.

But all in all, the economy has actually been stronger than many expected, but lower-income households are feeling the pinch. Pandemic savings are running dry, and debt levels are rising, with credit card limits getting maxed out.

But who knows if this will stay a problem for the lower-income groups or if it will start creeping up to the middle and upper income levels?

The economy has also changed big time. The old rules of the game— like the “Washington Consensus,” which focused on deregulation, fiscal discipline, and open markets— don’t apply anymore. 

Instead, America is seeing the rise of industrial policy, more fiscal imbalances, and weaponized trade tariffs.

Globally, the push for closer economic integration is being replaced by fragmentation, as countries work to rewire their own economies.

Global ramifications

Fitch’s report also touched on the international impact of the Fed’s cuts. In China, for instance, the People’s Bank of China surprised markets by cutting rates in July, lowering the 1-year medium-term lending facility rate from 2.5% to 2.3%. 

According to Fitch, the weakening US dollar and expected Fed rate cuts are giving China room to ease its rates further.

The Asian giant has been dealing with its own problems, especially with deflationary pressures building. Producer prices, export prices, and house prices are all dropping, while bond yields are in decline. 

Core CPI inflation in China has plummeted to 0.3%, prompting Fitch to lower its inflation forecasts even further, down to 0.5% for 2024.

Meanwhile, Japan is moving in the opposite direction. The Bank of Japan (BOJ) has been hiking rates more aggressively than expected, with a new level of confidence in their battle against deflation.

Bank of Japan headquarters in Tokyo

Core inflation has stayed above the BOJ’s target for 23 months straight, and Japanese companies are starting to offer consistent wage increases. 

This is a far cry from the country’s “lost decade” of the 1990s, where wages were stagnant, and deflation reigned.

Fitch expects Japan’s benchmark rate to hit 0.5% by the end of 2024, climbing to 1% by the end of 2026. The BOJ’s hawkishness is a massive threat to stock and crypto markets.

As for the European Central Bank, it cut its rates again just yesterday, and the region’s stocks have already surged a bit as an aftereffect.