The Federal Reserve will cut interest rates this week in response to slowing inflation, but this is just the first in a series of rate cuts that could boost the economy and help prevent a recession.

The size of the Fed's first rate cut remains an open question ahead of a key meeting, with a minority of investors betting on a modest 25 basis point cut rather than a larger 50 basis point reduction, according to CME FedWatch.

Whatever the outcome, most economists say the size of the first rate cut is immaterial. The more important question is where the Fed ultimately goes and how long it takes to get there.

Market consensus is that the Fed will cut its benchmark short-term interest rate to 3% by July next year from a 24-year high of 5.25% to 5.5%.

Some analysts, such as Luke Tilley, chief economist at Wilmington Trust and a former Fed official, see the Fed’s policy rate falling further, to 2.5%, next year.

The Fed is set to cut interest rates for the first time at the end of a two-day meeting in Washington on Wednesday, and investors expect the central bank to continue cutting rates sporadically over the next seven meetings until at least July 2025.

With inflation slowing sharply and unemployment rising, the Fed wants to cut high interest rates to avoid a recession.

The Fed’s fight against inflation is largely over. Inflation has slowed to 2.5%, not far from the Fed’s 2% target. Inflation, according to the Fed’s preferred PCE measure, is also well below its 40-year peak of 7.1% in mid-2022.

Wall Street’s view is likely to be informed by the Federal Reserve’s updated forecasts for U.S. inflation, economic growth, interest rates and unemployment this week.

Dot Matrix

The most closely watched is the so-called dot plot that depicts the path of rate cuts.

In June, the Fed had forecast just one rate cut in 2024 and just four more in 2025, but at that time inflation seemed more threatening and the labor market looked surprisingly strong.

The economic outlook has changed dramatically since June. Inflation has slowed rapidly after a small spike earlier this year, while the labor market has cooled sharply. Hiring in the three-month period from June to August fell to its lowest level since the pandemic. The unemployment rate has climbed to a more than three-year high of 4.2%.

Not surprisingly, the sluggish labor market has surpassed inflation as the biggest concern for the Federal Reserve, which is required by law to keep inflation stable and employment maximum.

“They’ve absolutely shifted their focus to the labor market,” said Tilley, who expects the first rate cut to be a more modest 25 basis points.

Those concerns have fueled expectations that the Federal Reserve will continue to cut interest rates through next summer: three cuts are expected in 2024 and no fewer than four in 2025.

Pace of rate cuts

Typically, the Fed prefers to raise or lower interest rates slightly when there is no crisis.

“If I were the Fed, I’m in no rush to cut rates. I’d cut by 25 basis points and measure it over the next year or so,” said Dan North, senior economist at Allianz Trade North America. “The economy is in good shape.”

On the other hand, he argued, a bigger rate cut would "send a panic message" and "scare the market."

Other economists said the size of the Fed’s first rate cut could depend on how weak the Fed believes the labor market is.

Most Fed officials say the job market has cooled as they expected, but concerns appear to be growing.

For example, Powell singled out the labor market in a major speech a few weeks ago, vowing that the Fed would do what was necessary to keep unemployment low in uncharacteristically hawkish language.

Citigroup economists said the Fed's anxiety is enough to spur at least a few 50 basis point rate cuts next year.

Economic situation

Whatever the outcome, lower interest rates will certainly give the economy a shot in the arm.

High borrowing costs have depressed home sales, curbed car purchases, limited business investment and kept the manufacturing sector depressed.

The Fed is raising interest rates to their highest levels since the turn of the century in 2022 and 2023 to quell the worst outbreak of inflation since the 1980s. Before the coronavirus pandemic, inflation was rising just 1.5% a year.

Many economists believe inflation could reach the Fed’s target, at least temporarily, in early 2025, rather than the 2026 that Fed officials forecast in June.

Tilley said PCE inflation "will reach the Fed's target by January of next year."

Eugenio Aleman, chief economist at Raymond James, agreed: "There will be a window next year where inflation will fall below 2%."

What is unclear is whether the Fed can hit its inflation target and keep it there.

Inflation Threat

Economists note that the federal government is still spending freely and the tap is unlikely to be turned off anytime soon, which would be an upside bet on inflation. Both presidential candidates have promised a slew of new spending or tax cuts.

"There is a strong tailwind on the fiscal side," Aleman said. The Fed knows the fiscal tailwinds are still there and will emerge.

Another potentially thorny issue for the Fed is high housing prices, the biggest source of inflation over the past few years.

By lowering interest rates, the Fed will make it less expensive to get a mortgage and spur more buyers to enter the market.

However, a surge in demand for new homes could cause house prices to surge again and add upward pressure on inflation.

Still, the Fed won’t be worrying about housing right now. Officials are intent on achieving a so-called soft landing, or lowering inflation without a recession. They are prepared to act aggressively if necessary.

Still, it will take time for the magic of lower borrowing costs to work its way through the economy.

“We’ve looked at what’s happened over the last 50 years,” North said. “It usually takes three to five quarters for rate cuts to boost the economy.”

Article forwarded from: Jinshi Data