"The Fed's Megaphone": Sharp rate cuts force the Fed to face new challenges

"Fed Whisperer" Nick Timiraos once again interprets the latest Fed interest rate decision.

Fed Chairman Powell boldly cut rates by 50 basis points, entering a new phase of the soft landing for the U.S. economy he seeks. However, this move has raised new questions that the Fed finds difficult to answer.

The rate cut did clarify an answer to a more important question, which is the Fed's overall goal. It emphasizes Powell's desire to prevent past rate hikes from pushing the economy into a recession in the face of declining inflation. But the main question that the Fed now struggles to answer is: To what level will the Fed cut rates, and how fast will the cuts be?

The Fed is unclear on both of these aspects. Fed officials typically focus on determining where their rates stand relative to the so-called neutral rate, which is unobservable.

Before the COVID-19 pandemic, most Fed officials believed the neutral rate had fallen to 2.5% or lower. Now, many believe this rate has risen. Possible reasons include soaring government deficits and new sources of investment demand.

Powell described the Fed's recent rate cut (lowering the federal funds target range to between 4.75% and 5%) as "adjusting policy over time to a more neutral level." While he usually avoids specific comments on the exact position of the neutral level, he voluntarily stated on Wednesday, "The neutral rate may be much higher than before the pandemic." "How high?" Powell said, "I think we don't know yet."

The pace of the Fed's rate cuts is also unknown, as Powell tries to discourage investors from assuming that a 50-basis-point cut at the November meeting should be the default path. Powell said, "The Committee does not feel a sense of urgency about this. I think no one should look at this and say, 'Oh, this is a new pace.'"

Ahead of this meeting, the Fed faced unusually unpredictable circumstances in deciding whether to start with the traditional 25 basis points or a larger 50 basis points cut, and the outlook for the Fed at the next meeting is that the continued mixed signals in the economy will bring similar uncertainties.

Before the meeting on November 6-7, officials will also receive two months of labor market data, including a report less than a week before the meeting.

Esther George, who stepped down as Cleveland Fed President in June, said that with cooling inflation, this week's decision represented a brave effort to manage the risks of a slowing hiring pace, but the imbalanced communication around this move ahead of the meeting could happen again. "At the next meeting, it will be '25 or 50, why not another 50 basis points cut?' So, things get more complicated," she said.

It is certain that Powell is trying to set a barrier to expectations of another 50-basis-point cut by pointing out the rate forecasts officials have disclosed. Dean Maki, Chief Economist at hedge fund Point72 Asset Management, said, "This is not entirely convincing, as the previous set of quarterly forecasts (in June) never signaled a 50-basis-point cut." Federal Reserve officials are trying to balance two risks: one is their procrastination on interest rate cuts, leading to rising unemployment rates, prompting officials to be eager for larger rate cuts.

Priya Misra, portfolio manager at Morgan Stanley Investment Management, said, "Before the labor market weakness leads to an economic downturn, this is a race between labor market slowdown and the Fed easing restrictions. If this is the beginning of labor market weakness, they should have a greater sense of urgency to continue to increase the rate of interest rate cuts."

Another risk is the Fed acting too quickly on interest rate cuts. Machi said, "If the Fed continues to cut rates by 50 basis points when the economy does not need it, the likelihood of inflation staying above the Fed's 2% target level will increase."

Mester said that even though tactical issues still exist, after Powell's speech at Jackson Hole, Wyoming last month, he took concrete action again this week, answering larger questions about the Fed's strategy.

Earlier speeches made it clear that he would not welcome further weakness in the labor market. "His speech in Jackson Hole was very clear," Mester said.

"I know everyone is focused on the 25 or 50 basis points question, but the important information is, listen, the committee is more confident that inflation will fall back to 2% over time, and they are also watching the risks in the labor market."

Powell is trying to strike a balance between expressing concerns about the economy and complacency about employment risks. He said, "This is worth paying attention to, and we are paying attention. Some people think that the time to support the labor market is when the labor market is still strong, not when layoffs begin."

In the past two weeks, more former Fed officials have urged the Fed to start with larger rate cuts to better balance the risks facing the economy, although some of Powell's colleagues' public statements suggest they would prefer to start with smaller rate cuts.

Powell prioritizes consensus building, as evidenced by the absence of dissenting votes in 17 consecutive meetings, but this week's meeting broke that record. Misra said, "I don't know if he can get the committee to agree, but he did it. So this also shows his influence on the committee."