Inside the Fed’s decision to cut rates

The day the Federal Reserve finally cuts interest rates is finally approaching. At their meeting on September 18th, the Federal Open Market Committee will slash the cost of money for the first time since 2021, ending a historic era of high rates.

But markets keep feeling uneasy at the uncertainty of the rate cut’s size. Investors are torn about which cut amount would be suitable for the current economic scenario. The choices are mainly two: a standard decrease of 0.25% or a larger-than-usual cut of 0.5%.

At the moment, interest rates on the US dollar are at their 23-year high of 5.25%-5.5%.

Such high rates have put significant pressure on the US economy but were needed to battle the highest inflations Americans have experienced since the 1980s. During this cycle, inflation in the United States reached a peak of 9.2% year-on-year. Prices in August 2024 were almost 20% higher than before the pandemic.

But the (understandably) aggressive hiking policy is now reaching a boiling point. GDP growth in the United States is declining, with estimates saying it will barely break 2% in the current quarter.

Unemployment increased by 0.8% since last year, with average jobless claims in 2024 close to the post-2008 recession slug.

At the same time, inflation has not yet been entirely defeated. The Consumer Price Index dropped to 2.5% in August, lower than expected but still half a percentage point above the Fed’s target.

Soft or hard landing?

The real question on everyone’s mind is whether the US economy will slow down to the point of recession. Although most banks believe it’s less likely than a soft landing, the odds of a recession in the United States are rising.

“There is a fragility out there when you are not hiring at a very strong pace,” Diane Swonk, chief economist at KPMG, said. “This is still a much weaker labor market than we thought we had.”

Goldman Sachs raised its recession probability in the next 12 months from 15% to 20%. After markets were seemingly on the brink of collapse on August 5th, Goldman Sachs had raised it to 25%.

That would seem to suggest a 50-point cut is the best in the current scenario, as it would propel the US economy further.

However, other economists are quick to point out that the US economy is already strong, albeit not as much as one year ago. Unemployment rose but is still close to all-time lows. The economy added 116,000 new jobs in August, far above the 89,000 July increase.

Moreover, the defeat of inflation is anything but given. A more cautious approach, such as cutting rates by 25 basis points, would ensure a stable path for prices to reach their target.

Fed Chairman Jerome Powell was very careful not to reveal its intentions. Markets will discover the final decision on September 18th.