The Federal Reserve is facing a difficult decision: should it cut interest rates by 50 basis points next week, or cut them more slowly by 25 basis points?
Questions about how big the cut will be come as futures markets increasingly favor a more modest 25 basis point rate cut by the Federal Reserve after its key meeting next Thursday.
Any rate cut next week would be the first by the Fed in more than four years and would come after keeping rates at a 23-year high of 5.25% to 5.5% since July last year, seven weeks before the U.S. presidential election in November.
Fed officials are unanimous in their support for rate cuts as inflation shows signs of slowing and they are focused on preventing excessive economic damage from keeping borrowing costs higher than necessary. How quickly to return to a "neutral" level that does not curb economic growth is the next question they must answer.
However, the Fed's 50 basis point rate cut in September will allow the Fed to return borrowing costs to normal levels more quickly, remove its stranglehold on the economy and protect the labor market from further weakness. Krishna Guha, vice chairman of Evercore ISI, said a 50 basis point rate cut by the Fed next week "will reduce the risk of a soft landing."
Even if the Fed chooses to move slower next week, it could adjust policy quickly, as it could if inflation proves more stubborn than expected in 2022, said Donald Kohn, a former Fed vice chairman. “If they wait too long, they do have an opportunity to make up for it with the speed of their rate cuts and the signals they give about future rate cuts,” he said.
Policymakers have yet to sound the alarm about the outlook for the U.S. economy, but have warned of rising downside risks. The minutes showed some thought a rate cut was "justified" at the most recent meeting. Since then, employment and inflation data have turned more favorable for a rate cut.
Federal Reserve Chairman Jerome Powell said last month that the Fed will "do everything we can to support a strong labor market as we make further progress toward price stability."
Fed Governor Waller said on Friday he was "open-minded about the size and pace of rate cuts" and would support a bigger cut if the data indicated it was necessary. But he said he expected any action would be "carefully conducted."
Also on Friday, New York Fed President John Williams said he had not yet decided how much to cut interest rates this month, but he said the Fed is "well positioned" to achieve its inflation and employment goals. "We'll get together and we'll analyze everything and talk about it," he told reporters about the size of the first rate cut.
However, a more aggressive 50 basis point rate cut by the Fed this month would also come with risks.
Recent data has been mixed, with the latest jobs report showing slower monthly growth but a drop in the unemployment rate and rising wages. Inflation data this week showed price pressures easing, with even core inflation in the consumer price index, which strips out volatile food and energy prices, stabilizing.
A 50 basis point rate cut could also stoke concerns that the Fed is growing increasingly concerned about the economic outlook. It could also prompt financial markets to price in a steeper cut in rates beyond the Fed’s planned pace of easing.
“The Fed could defend a 50 basis point rate cut, but the communications around that are complicated and there is no compelling reason to take on that challenge,” said Cleveland Fed President Loretta Mester, who retired in June.
Richard Clarida, a former Fed vice chairman and current Pimco executive, said a 50 basis point rate cut "is not 100 percent guaranteed to be well received or boost confidence, and it could lead to a view in the market of, 'Wow! Does the Fed know something that we don't?'"
Considering that Republican presidential candidate Trump has previously warned the Fed not to cut interest rates in September, a larger-than-expected rate cut would also pose political risks to the Fed.
Powell recently said the Fed would "never use our tools to support or oppose any party, politician or any political outcome."
Futures markets indicate the Fed will cut interest rates by 1 percentage point by the end of the year, which means the Fed will cut rates by 50 basis points at least once in the three remaining meetings.
