"New Federal Reserve Newsletter" Ultimate Preview of September Meeting: Complex Situation, Uncertainty Remains on First Rate Cut Magnitude

On Tuesday, well-known financial journalist Nick Timiraos, also known as the "New Fed News Agency," wrote that the Federal Reserve is about to cut interest rates, but the magnitude of the first rate cut remains uncertain. The Federal Reserve typically tends to act with a 25 basis point adjustment, but this time, the situation has become more complex.

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

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

Federal Reserve officials tend to adjust interest rates by 25 basis points to study the impact of these measures. However, when they believe that their rate stance is inconsistent with risk balance, they act more quickly. For example, in 2022, the Federal Reserve raised rates by 50 basis points and 75 basis points to address high inflation.

Recent economic data in the United States over the past few months has shown a steady decline in inflation, moving towards the Federal Reserve's 2% target. However, the labor market has cooled down, 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 has slowed to an average of 116,000, compared to 212,000 in December 2023.

Timiraos pointed out that until late last week, investors were still expecting a 25 basis point rate cut at the Federal Reserve's September meeting, as few Federal Reserve officials openly called for further rate cuts. Based on the communication of Federal Reserve officials, it seems that the rate cut in September will be 25 basis points, and the economic data is still decent.

The quiet period before the Federal Open Market Committee (FOMC) meeting began on September 7th. Timiraos listed several speeches by senior Federal Reserve officials, showing their hesitation about the rate cut magnitude on the eve of this quiet period:

Federal Reserve 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 rate cuts in advance." At that time, Waller did not seem concerned about the recent slowdown in US job growth. He said, "Even if monthly job growth falls to 100,000, it's okay, there's nothing to fear."

Also on September 6th, the number three figure at the Federal Reserve, New York Fed President Williams, said, "Recent data shows that this is a fairly common trend, what we are seeing is a continued cooling signal, we hope the economy can balance and stay balanced."

Timiraos said that Federal Reserve officials often refer to their work as risk management - for example, weighing the risks of escalating inflation against the risks of accelerating unemployment. They often set rates to address risks that appear to be more costly. For much of the past two and a half years, as inflation rates soared above 7%, risk management tended to take a more aggressive approach to prevent entrenched inflationFrom the perspective of risk management, Timiraos quoted former Dallas Fed President Robert Kaplan's views:

If officials consider which mistake they would regret less at this week's meeting, it is reasonable to start a rate-cutting cycle with a 50 basis point cut.

If I were back in my original position, I would say, I can accept 25 basis points, but I prefer 50 basis points. Considering the current situation of inflation and unemployment rate, 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 economic weakness that would 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 less likely to regret the large rate cut, as rates will still be at relatively high levels. But if the Fed takes smaller rate cut measures and the labor market deteriorates faster, officials will feel more regretful.

The Fed's July minutes showed that some officials were satisfied with a 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 delayed a meeting, which was controllable, but if they could do it over, I hope they would have cut rates in July. I would rather correct this now, take the initiative, than fall behind the situation throughout the fall and chase the declining economy.

Timiraos also extensively quoted former Fed senior advisor William English in the article:

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 some insurance, with a larger rate cut of 50 basis points.

Reasons for a smaller rate cut of 25 basis points include: strong economic fundamentals, or a too rapid rate cut that 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 fight against inflation will be more prolonged and unsettling.

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

The decision this week is fifty-fifty, which may reflect Fed officials' uncertainty 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. There is a group of people who are really unsure about what to do here. In the end, Powell may reach a reasonable consensus on either one of them.

Next Steps

Timiraos pointed out that the Fed's choice will be supplemented by quarterly economic forecasts, which show officials' expectations for where rates will be 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 policymakers' rate outlook can affect a range of borrowing costs such as mortgages, auto loans, and commercial debtForecasts for the September meeting are particularly valuable, as there are only two meetings left this year, in November and December. The September forecasts provide unusually specific views for the two subsequent meetings.

If more officials expect a total rate cut of 1 percentage point this year, it implies there will be at least one 50 basis point 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 a 25 basis point cut in September, with expectations of the same magnitude of cuts at the last two meetings of the year, while retaining the option to accelerate the pace of rate cuts if the economy deteriorates.

Given the difficulty in distinguishing between the two possible outcomes of this week's decision, Powell may face opposition from at least one policy maker. The 12 voting officials include 5 regional Fed presidents and 7 governors based in Washington. In the past two years, no Fed official has dissented from a policy decision, matching a similar record over the past half century. Additionally, no Fed governor has dissented on an interest rate decision since 2005.