With no crisis in sight, why did the Federal Reserve explode with a 50 basis point rate cut? "The Federal Reserve's Echo Chamber" explains

"The Federal Reserve's megaphone," well-known journalist Nick Timiraos from The Wall Street Journal, interprets the latest interest rate decision by the Federal Reserve.

The Federal Reserve voted to cut interest rates by 50 basis points, marking the first rate cut since 2020 and opting for a more bold start. Two years ago, the Federal Reserve launched a comprehensive campaign to raise interest rates to combat inflation, and the long-awaited policy shift has finally arrived.

Out of the 12 Federal Reserve voters, 11 supported the rate cut, bringing the federal funds target rate range down to between 4.75% and 5%. The latest quarterly forecasts indicate that most officials expect to cut rates by at least 25 basis points at the November and December meetings.

Federal Reserve Chairman Powell's decision to cut rates this time exceeded the expectations of most analysts. This decision firmly places the Federal Reserve into a new phase of the inflation battle: last year's rate hikes pushed borrowing costs to a twenty-year high, and now the Federal Reserve is trying to prevent past rate hikes from further weakening the U.S. labor market.

Powell said at a press conference, "We are committed to maintaining our economic strength. This decision reflects our increasing confidence that by adjusting our policy stance appropriately, we can maintain the strong momentum in the labor market."

In its policy statement, the Federal Reserve stated that this decision reflects "increased confidence in the continued progress toward 2% inflation" and that the Federal Reserve "judges that the risks to achieving its employment and inflation goals are roughly balanced."

This rate cut should immediately ease the pressure on consumers with credit card balances and small businesses with floating rate debt. With expectations of a series of rate cuts this autumn, especially after Powell's announcement of an impending rate cut last month, long-term borrowing costs from mortgages to corporate debt have already started to decline.

This week's rate cut seemed inevitable, but analysts were unusually unclear about the size of this rate cut. Many expected the rate cut to be less than 25 basis points. Federal Reserve officials typically prefer to make smaller changes to avoid having to change direction if their actions are proven premature.

Powell apparently decided to push his colleagues to cut rates by 50 basis points, which likely reflects so-called risk management issues, where officials weigh various economic risks such as high inflation or rising unemployment rates and take corresponding measures.

For most of the past two years, when the inflation rate reached 7%, Powell has been focused on preventing inflation from becoming entrenched. Examples from the 1970s have long plagued central bank governors around the world, as they did not take sufficient measures to limit demand, allowing price increases to become self-fulfilling expectations. However, over the past year, with supply chains repaired and a large number of workers entering the job market, the inflation rate has declined. This indicates that while many economists once believed that an economic recession was needed to curb inflation, it now appears that such an approach was an overcorrection.

Meanwhile, more signs indicate that the labor market is weakening. The unemployment rate last month was 4.2%, higher than January's 3.7%. Powell stated last month that he is shifting the Federal Reserve's focus to preventing what appears to be a mild cooling of labor demand from turning into a deeper freeze In their projections, all Federal Reserve officials believe that the unemployment rate at the end of this year will range between 4.2% and 4.5%. In June, most officials believed that the year-end unemployment rate would stabilize around 4.0%.

In recent weeks, some Fed officials have felt that the economy has not weakened enough to warrant a 50 basis point rate cut, while others believe that a larger rate cut is needed this summer as the labor market cools, because the Fed is essentially making up for lost time. Fed officials discussed the rate cut issue at their meeting at the end of July, but ultimately chose not to cut rates. Two days later, job data showed a greater-than-expected slowdown in job growth, leading to a significant increase in the unemployment rate. If they had seen this data at the July meeting, they might have chosen to cut rates at that time. This week's larger rate cut provides them with a reset opportunity.

Some officials also feel a rate cut is more necessary because they are increasingly convinced that rates are well above the so-called neutral level, and even after the rate cut on Wednesday (local time), rates will remain at a restrictive level. As the economy moves closer to a healthy balance, maintaining this state requires bringing rates closer to a neutral level, which is unobservable.

Powell said, "We don't think we're behind. You can think of this as our commitment not to fall behind."

Fed Governor Bowman dissented from Wednesday's decision, supporting only a 25 basis point rate cut. Bowman, appointed by Trump in 2018, became the first governor since 2005 to dissent on a rate decision. This is also the first time since June 2022 that any voting member of the rate-setting committee has dissented.

The Fed's rate cut marks the sixth time in the past 30 years that the central bank has switched from raising rates to cutting rates. Typically, when the Fed starts cutting rates, it doesn't know whether it will take small actions like in 1995 and 1998 to avoid a recession, or start a series of longer rate cuts months before a recession as in 2001 and 2007.

Rate forecasts indicate that assuming the unemployment rate does not spike and inflation continues to decline, officials expect to cut rates 4 more times by next year, by 25 basis points each time. By the end of 2025, the Fed funds rate is expected to be slightly below 3.5%. Ahead of the fall elections, officials are trying to achieve a soft landing by lowering inflation without causing an economic recession, while also working to avoid clashes with politicians, striking a delicate balance between the two.

Three Senate Democrats, including Elizabeth Warren of Massachusetts, called on Powell this week to increase the rate cut to 75 basis points, a move the Fed would only make if the economy were clearly in trouble. Some Republicans may be uneasy about a rate cut before the November elections. "Cutting rates is a signal of an economic downturn, otherwise you wouldn't do it," Trump said at a town hall meeting on Tuesday night Federal Reserve Chair Jerome Powell has stated that the Fed will not consider political factors. Patrick McHenry, chairman of the House Financial Services Committee, expressed in an interview on Tuesday that he hopes the Fed will not pay attention to political noise. He said, "The Fed should act according to the data."

Unlike the significant rate cuts by the Fed in 2001 and 2007, the current economy is not experiencing obvious financial market pressure or asset bubble expansion. On the other hand, for corporate borrowers who locked in much lower fixed borrowing costs before 2022, a moderate rate cut may not be of much help as they will need to refinance next year, even if the Fed lowers rates, their rates may still be high.

Furthermore, due to the severe challenges facing economic resilience, it is not yet clear to what extent the marginal rate cuts can stimulate housing activity. Although mortgage rates have seen a meaningful decline in recent weeks, there are no clear signs of increased demand. Despite a significant drop in mortgage rates, last week's mortgage applications did not exceed levels from a year ago. Rates dropped to 6.2% last week, the lowest level in over a year and a half.

Former Chief Investment Strategist at Bridgewater Associates, Rebecca Patterson, said that just as Fed officials and private sector economists misjudged two years ago how households and businesses locking in low rates would weaken the transmission of rate hikes to the economy, the easing cycle may also face similar challenges.

Bond investors expect another 2 percentage point rate cut in the next year, while stock valuations indicate that investors expect healthy earnings growth next year. Patterson said: "To achieve all this, you need to see the Fed's accommodative policy supporting consumer and business activity. The channels cannot be blocked."