Author: He Hao

Source: Wall Street News

On Tuesday, well-known financial journalist Nick Timiraos, also known as the "New Fed Communication Agency," wrote that the Fed is about to cut interest rates, but the magnitude of the first rate cut remains uncertain. The Fed usually tends to act in increments of 25 basis points, but this time, the situation has become more complicated.

Timiraos straightforwardly stated that the current Fed's benchmark interest rate is 5.25%-5.5%, the highest level in 20 years. The Fed is expected to start cutting interest rates this Wednesday, aiming to maintain a stable job market in the face of cooling inflation pressures.

Timiraos believes that whether the Fed will cut the benchmark interest rate by a larger 50 basis points or the traditional 25 basis points will depend on how Fed Chairman Powell leads his colleagues in a series of delicate considerations.

Generally, Fed officials tend to raise or lower interest rates by 25 basis points to study the impact of these measures. However, when they believe that their interest rate stance is inconsistent with risk balance, they will act more quickly. For example, in 2022, the Fed raised interest rates by 50 and 75 basis points to combat high inflation.

Economic data in the United States over the past few months has shown that inflation has steadily declined, moving towards the Fed's 2% target. However, the labor market has cooled, with the unemployment rate rising from 3.7% at the end of last year to 4.2% in August. In the three months ending in August, monthly non-farm payroll growth slowed to an average of 116,000, compared to 212,000 in December 2023.

Timiraos pointed out that until late last week, investors expected the rate cut at the Fed's September meeting to be only 25 basis points, as few Fed officials publicly called for further rate cuts.

The Fed's FOMC meeting's quiet period began on September 7th. Timiraos listed several speeches by senior Fed officials, reflecting their hesitation about the magnitude of the rate cut on the eve of this quiet period:

Fed Governor Waller stated after the latest non-farm payroll report released on September 6th, "When inflation accelerated in 2022, I strongly advocated for preemptive rate hikes, and if appropriate, I would also advocate for preemptive rate cuts." At that time, Waller did not seem concerned about the recent slowdown in U.S. job growth. He said that even if monthly job growth fell to 100,000, it would be okay, and there was nothing to fear.

Also on September 6th, the third-ranking Fed official, New York Fed President Williams, said, "Recent data shows that this is a fairly common trend, and what we see is a continued cooling signal. We hope the economy can balance and remain balanced."

Timiraos said that Fed officials often refer to their work as risk management—weighing the risks of escalating inflation against accelerating unemployment. They often set interest rates to address those risks that appear to be more costly. For most of the past two and a half years, as the inflation rate soared to over 7%, risk management tended to take a more aggressive approach to prevent entrenched inflation.

From a risk management perspective, Timiraos cited the views of former Dallas Fed President Robert Kaplan:

If officials consider which mistake they would be less regretful about at this week's meeting, it is reasonable to start the rate cut cycle with 50 basis points.

If I were back in my original position, I would say I could accept 25 basis points, but I would prefer 50 basis points. Given the current situation of inflation and unemployment, the Fed's benchmark interest rate should be about 1 percentage point lower than it is now. If I were starting from a blank slate, I would say the rate should be around 4.5%.

Since inflation has not been completely defeated, the Fed should avoid further weakening of the economy, which could force faster or deeper rate cuts, as this could reignite inflation.

If there is a significant rate cut this week, and the economic conditions are good by the next meeting in early November, Fed officials are unlikely to regret the significant rate cut, as the rate will still be at a relatively high level. But if the Fed takes a smaller rate cut this week and the labor market deteriorates more quickly, officials will feel more regretful.

The minutes of the Fed's July meeting showed that some officials were satisfied with the rate cut at that time, but most preferred to wait. The July non-farm payroll data released after the Fed's July meeting was much weaker than expected. The Fed was late for one meeting, which was controllable, but if they could do it again, I hope they would have cut rates in July. I would rather correct this now and take the lead, than fall behind the situation for the entire autumn, chasing a declining economy.

Timiraos also extensively quoted former Fed senior advisor William English:

For the Fed, the key issue at this meeting is their understanding of risk balance. If they are more concerned about growth and employment than inflation, they are likely to want to increase insurance, with a larger rate cut of 50 basis points.

Reasons for a smaller rate cut of 25 basis points include: good economic fundamentals, or the risk that a rate cut too quickly could trigger market risk-taking, thereby maintaining a higher level of inflation. If the Fed does not believe that inflation is really as good as recent data shows, they may still be concerned that the struggle against inflation will be more prolonged and unsettling.

A few weeks ago, English said he thought a smaller rate cut was appropriate. But the downward trend in recent labor market data has made him more nervous, especially because even after two or three rate cuts, the rate will still be at a relatively high level.

The decision this week is a toss-up, which may reflect the uncertainty of Fed officials about the right choice. It's not that half of the committee supports 50 basis points and the other half supports 25 basis points, and then they argue with each other. The current situation is that a group of people really don't know what the right thing to do here is. In the end, Powell may reach a reasonable consensus on any of these.

Next Steps

Timiraos pointed out that the Fed's choice will be supplemented by quarterly economic forecasts, which show officials' expectations for the level of interest rates at the end of the year. Although these forecasts are not the result of committee discussions, they are equally important to financial markets, as the Fed's rate outlook can affect a range of borrowing costs, including mortgages, car loans, and business debt.

The forecasts for the September meeting are particularly valuable, as there are only two meetings left after this year, the November and December meetings, and the September forecasts provide unusually specific views for the subsequent two meetings.

If more officials expect a total rate cut of 1 percentage point this year, it means there will be at least one 50 basis point rate cut this year. Delaying a larger rate cut until later this year could raise awkward questions: why is this the best course of action? Another option is to cut rates by 25 basis points in September and expect the same rate cut at the last two meetings of the year, with the option to accelerate the rate cut pace if the economy deteriorates.

As the two possible outcomes of this week's decision are difficult to distinguish, Powell may face opposition from at least one policy maker. The 12 voting officials include 5 regional Fed presidents and 7 Fed governors based in Washington. In the past two years, no Fed officials have opposed a policy decision, matching a similar record for the longest time in the past half century. In addition, since 2005, Fed governors have never dissented on interest rate decisions.

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