Will Fed start rate cuts by 0.25% or 0.5%?

It is now widely expected that the US Federal Reserve will begin slashing interest rates at its upcoming meeting on Sept. 17-18, marking the first cut in borrowing costs since 2020.

However, policymakers face a difficult decision regarding the pace at which to ease monetary policy. They have two options: either to start with a moderate cut of 25 basis points (bps) or to make a stronger move by reducing rates by 50 bps.

Federal Reserve Chair Jerome Powell has kept all options on the table, stating during the Jackson Hole symposium in August: "It's time to adjust monetary policy, but the timing and pace of the cuts will depend on the data, forecasts, and the balance of risks."

After the US central bank tightened its monetary policy between early 2022 and mid-2023 at the fastest pace since the early 1980s to combat inflation, raising interest rates from a range of 0-0.25% to 5.25%-5.5%—the highest level in 23 years—it has kept rates at that level for the past 14 months.

The Fed has only three monetary policy meetings left this year in September next week, the November meeting, and the final one in December.

The quarterly economic forecasts, to be released at the September meeting, will reveal how many rate cuts officials expect this year. These forecasts may be as important as the actual rate cut decision, as markets anticipate a reduction of more than 100 bps in 2024.

It’s Time to Cut Interest Rates

Fed officials are now convinced of the need to reduce interest rates, supported by job and inflation data. They are focused on preventing unnecessary economic damage caused by keeping borrowing costs high for too long.

The latest monthly report showed a slowdown in job growth but also highlighted lower unemployment and higher wages. This week’s data also pointed to easing price pressures.

Christopher Waller, a Federal Reserve official, stated during a speech at the University of Notre Dame that the time has come to start cutting interest rates, but with caution, noting that a more aggressive move is only warranted if the data supports it.

Similarly, John Williams, President of the Federal ReserveBank of New York, mentioned that inflation is steadily decreasing toward the bank's 2% target, and it is now time to reduce interest rates.

A Moderate Start

The Fed typically prefers a move of 0.25% or 25 bps, as small adjustments in monetary policy allow more time to assess their impact on the economy. This view was supported by Esther George, former president of the Kansas City Federal Reserve (2011–2022), who said, "A 25-basis-point move is easy at the start."

According to the CME FedWatch Tool, there is a 45% probability of a 50-basis-point rate cut, while the likelihood of a 25-bps cut stands at 55%.

Fitch, in a memo, noted that the upcoming rate-cutting cycle by the Fed will be moderate by historical standards, with expected cuts of 25 bps at both the September and December meetings, followed by a cumulative 125-basis-point reduction in 2025 and 75 bps in 2026.

The credit rating agency explained that one reason it expects a relatively moderate pace of interest rate cuts is that there is still work to be done on inflation, which remains above the Fed’s 2% target.

Additionally, a larger move in the September meeting might lead markets to mistakenly believe that the Fed plans similar reductions in the November and December meetings.

The Larger Option

The US Central Banktypically opts for a larger rate cut when financial markets show clearer warning signs about economic outlooks, as seen in early 2021 and during the onset of the global financial crisis in 2007.

A 0.5% or 50-basis-point cut in September would allow the Fed to return borrowing costs to more normal levels more quickly, removing constraints on the economy and protecting the labor market from further weakening.

Nobel laureate economist Joseph Stiglitz supports a 50-basis-point rate cut at the Fed’s next meeting.

On the other hand, Jennifer Lee, a senior economist at BMO Capital Markets, told Yahoo Finance that a 50-basis-point cut could cause panic.

Meanwhile, Michael Yoshikami, CEO of Destination Wealth Management(DWM), believes that a larger cut would demonstrate the Fed's readiness to act without signaling concerns about a broader slowdown. He views it as a positive sign that the Fed is doing what is necessary to support job growth and would not be surprised if the cut is 50 basis points.

Another Aspect

Donald Kohn, former Vice Chairof the Fed, noted that even if the Fed chooses a slower pace of action next week, it can quickly adjust its policy if needed. They have the opportunity to make up for it if they wait too long through the speed at which they cut and how they signal future cuts, he added.

Additionally, a deeper-than-expected rate cut could risk a political backlash. For instance, Republican candidate Donald Trump previously warned the Fed against any rate cuts in September, a few weeks before the presidential election.

However, Powell recently stated that the Fed would never use its tools to support or oppose any political party, individual, or political outcome.

Source: The Economist, WSJ, CNBC, Financial Times, Market Watch