Fed expected to announce its first interest rate cut since 2020

Washington (AFP) – The Federal Reserve is gearing up to announce its first interest rate cut for more than four years on Wednesday, with policymakers expected to debate how big a move to make less than two months before the US presidential election.

Senior officials at the US central bank including Fed chair Jerome Powell have in recent weeks indicated that a rate cut is coming this month, as inflation eases toward the bank's long-term target of two percent, and the labor market continues to cool.

The Fed, which has a dual mandate from Congress to act independently to ensure both stable prices and maximum sustainable employment, has repeatedly stressed it will make its decision on rate cuts based solely on the economic data.

But a cut on Wednesday could still cause headaches for Powell, as it would land shortly before the election, in which former Republican president Donald Trump is running against the current Democratic vice president, Kamala Harris.

"As much as I think the Fed tries to say that they're not a political animal, we are in a really wild cycle right now," Alicia Modestino, an associate professor of economics at Northeastern University, told AFP.

How big a cut?

The debate among policymakers on Tuesday and Wednesday this week will likely center on whether to move by 25 or 50 basis points.

The Fed's benchmark lending rate currently sits at a 23-year high of between 5.25 and 5.50 percent © Samuel BARBOSA / AFP

However, a rate cut of any size would be the Fed's first since March 2020, when it slashed rates to near-zero in order to support the US economy through the Covid-19 pandemic.

The Fed started hiking rates in 2022 in response to a surge in inflation, fueled largely by a post-pandemic supply crunch and the war in Ukraine.

It has held its key lending rate at a two-decade high of between 5.25 and 5.50 percent for the past 14 months, waiting for economic conditions to improve.

Now, with inflation falling, the labor market cooling, and the US economy still growing, policymakers have decided that conditions are ripe for a cut.

Policymakers are left with a choice: making a small 25 basis point cut to ease into things, or a more aggressive cut of 50 basis points, which would be helpful for the labor market but could also risk reigniting inflation.

"I think that in advance of the November meeting, there's not quite enough data to say we're in jeopardy on the employment side," said Modestino, who was previously a senior economist at the Federal Reserve Bank of Boston.

Analysts see the smaller cut as a safe bet.

"We expect the Fed to cut by 25bp (basis points)," economists at Bank of America wrote in a recent note to clients.

"The Fed likes predictability," Modestino from Northeastern said. "It's good for markets, good for consumers, good for workers."

"So a 25 basis point cut now, followed up by another 25 basis point cut in November after the next round of economic data, offers a somewhat smoother glide path for the economy," she added.

How many cuts?

While analysts overwhelmingly expect the Fed to start cutting in September, there is less clarity about what comes next.

Economists at some banks, including Goldman Sachs, expect cuts totaling 75 basis points over the last three meetings of the year, while others see more aggressive cuts, like economists at Citi, who have 125 basis points of easing as their base case.

"The continued softening of the labor market is likely to provoke larger-sized cuts if not at this FOMC meeting then in November and December," the Citi economists wrote in a recent note to clients, referring to the rate-setting Federal Open Market Committee (FOMC).

The Fed will shed some light on the issue on Wednesday, when it publishes the updated economic forecasts of its 19-member FOMC -- including their rate cut expectations.

In June, FOMC members sharply reduced the number of cuts they had penciled in for this year from a median of three down to just one amid a small uptick in inflation.

But as inflation has fallen and the labor market has weakened, expectations of more cuts have grown.

Traders also see a greater-than 99 percent chance of at least four more cuts in 2025, which would bring the Fed's key lending rate down to between 3.5 and 3.75 percent -- 175 basis points below current levels.