Uncertainty looms! Is a slight interest rate cut by the Federal Reserve this week still the best option?

Imagine driving a car with a windshield covered in mud, where the driver can only see through the rearview mirror, relying solely on past routes to determine future directions. This is a significant challenge. However, when it comes to judging the direction of interest rates, the Federal Reserve has no choice.

A month ago, the Federal Reserve unexpectedly lowered interest rates by 50 basis points, surprising some investors and consumers. Recently, however, the U.S. economy has shown some signs of improvement. Nevertheless, Federal Reserve Chairman Jerome Powell hinted that a smaller rate cut of 25 basis points would be made when the Federal Open Market Committee (FOMC) concludes its rate decision meeting on November 6-7.

Officials have suggested that they want to preemptively address a softening labor market while cutting borrowing costs, but employment has grown for four consecutive months and unexpectedly surged in September. The Labor Department recently revised summer employment data, indicating that the situation is not as dire as initially thought. Meanwhile, the U.S. economy grew at a healthy rate of 2.8% in the third quarter of this year, driven by strong consumer spending.

However, the Federal Reserve has not yet emerged from this fog-covered forest. Devastating hurricanes sweeping through parts of North Carolina and Florida, along with strikes by Boeing factory workers, have had an extremely negative impact on October's non-farm data, although these effects may be temporary.

Data sometimes appears strong and at other times concerning, illustrating the complexity of setting interest rates in the context of lagging and frequently revised data. Some prominent economists, such as former Treasury Secretary Lawrence Summers, have even labeled the Federal Reserve's 50 basis point rate cut as a "mistake," as data begins to show a better trend.

In speeches prior to the Federal Reserve meeting, officials indicated that they still believe their benchmark borrowing rate is too restrictive for the economy.

However, this move is bound to push them into the political spotlight they often try to avoid, as it comes just two days after Americans vote for either President Trump or Vice President Harris to enter the White House. Economists point out that both candidates could lead to different economic outcomes, with Trump favoring tariffs and tax cuts, while Harris supports tax increases on the wealthy, exacerbating uncertainty.

Greg McBride, Chief Financial Analyst at Bankrate, noted, "Compared to the rate hikes of 2022 and 2023, the Federal Reserve will lower rates at a more cautious pace, meaning the U.S. will not quickly transition from a high-rate environment back to a low-rate environment. We are moving from a high-rate environment to one with less high rates."

Did the Federal Reserve Really Make a Mistake in September?

The decision to lower interest rates by 50 basis points was not unanimous. Federal Reserve Governor Michelle Bowman became the first dissenting member of the Federal Reserve Board since 2005, preferring a smaller rate cut of 25 basis points.

The minutes from the Federal Reserve's September meeting were released three weeks after the decision was made, indicating that Powell persuaded officials to support a larger rate cut. "Some participants" preferred a 25 basis point cut, the records stated, noting that "some" participants indicated that a smaller cut would help them assess the extent of the rate decrease and will not take on greater inflation risks.

"The Federal Reserve is a target for criticism. They usually get blamed when they are wrong, and they also get blamed when they are right," said Ryan Sweet, chief economist at Oxford Economics. "The market narrative has run too fast; they are even pricing in a collapse in the job market, which is not actually the case."

By implementing larger rate cuts in September, Federal Reserve officials clarified their priorities: the risk of inaction outweighs the risk of over-cutting rates.

"You can argue it from both sides," McBride said. "I belong to the camp that sees this as a good insurance measure. If needed, they can slow down the rate cuts in the coming months."

When asked whether strong job growth means the Federal Reserve should not cut rates as aggressively, San Francisco Fed President Mary Daly stated in a speech in New York in mid-October that the Federal Reserve has no evidence that stronger hiring exacerbates inflation.

"I strongly oppose stifling expansion out of fear," she said. "We should not stifle job growth and good growth as long as it does not lead to inflation."

Federal Reserve officials still believe that the slowdown in inflation is providing room for them to adjust borrowing costs. The Fed's preferred inflation measure—the Personal Consumption Expenditures (PCE) index—rose 2.1% year-on-year in September, essentially reaching the Fed's 2% target.

The slowdown in inflation means that Federal Reserve officials may not need to suppress economic growth as they did before.

A popular way to measure the impact of interest rates on the financial system is to subtract the nominal rate from the current inflation rate to derive the so-called "real" interest rate level. According to these measures, borrowing costs are now more suppressive to the U.S. economy than they were at their peak in 2023.

"I don't think they will regret it," Sweet said. "The economy is performing well, the job market is generally balanced, and the 'magic bottle' of inflation has largely been capped. They won't be as aggressive as in September, but monetary policy remains restrictive, so now is the time for the Fed to ease off the brakes."

Federal Reserve officials seem to be slowing down rate cuts unless circumstances change

The Federal Reserve's recent interest rate forecasts suggest two more rate cuts in 2024, each by 25 basis points, totaling four cuts by 2025. If these measures are realized, the Fed's benchmark rate would be in the target range of 3.25% to 3.5%—2 percentage points lower than the peak rate but still higher than any period since the Great Recession of 2007 to 2009.

However, these rate cuts are not yet certain. Powell stated that Federal Reserve officials will have to decide how to handle interest rates based on data and economic conditions.

In late September, Powell said, "Looking ahead, if the economy develops broadly as expected, policy will shift to a more neutral stance over time; we do not have a preset path." In a speech in October, Federal Reserve Governor Christopher Waller introduced several economic scenarios and potential policy responses that the Federal Reserve might take. He stated:

"If inflation continues to gradually ease while the labor market remains stable, Federal Reserve officials could lower interest rates at a 'measured' pace. Meanwhile, if inflation drops sharply or the labor market deteriorates, Federal Reserve officials would respond with more aggressive rate cuts. In the final scenario, if inflation intensifies, it would mean that Federal Reserve officials could pause rate cuts until progress is made and uncertainty is reduced."

Dan North, a senior economist at Allianz Trade North America, is skeptical that the inflation issue has been fully resolved. He pointed out that some aspects of inflation remain stubborn. For example, in the PCE index, excluding food and energy, price increases have reached their highest level since April. Overall, the annual inflation rate has stagnated at 2.7% since July.

At the same time, he also sees weakness in the labor market. The hiring rate is currently at its lowest level since 2015, and the proportion of workers unemployed for 27 weeks or longer is at its highest level since 2017.

"For the Federal Reserve, the hardest part is predicting the future, and it always has been," North said. "They must pay attention to long-term trends and gather as much data as possible. What I see overall is that inflation has not convincingly dropped to 2%, and growth is undoubtedly slowing."

Sweet's rate cut forecast at Oxford Economics aligns with the Federal Reserve's predictions, but he noted that there is uncertainty. He said, "If the Federal Reserve takes any action, our forecast risks lean towards fewer rate cuts."

Since the Federal Reserve cut rates, some interest rates have actually risen

According to interest rate data tracked by Bankrate, since the Federal Reserve cut rates in September, interest rates on credit cards, auto loans, home equity lines of credit, and other loans have begun to decline in the market. However, other borrowing costs have unexpectedly increased.

According to Bankrate's weekly national rate survey, since the Federal Reserve cut rates by 50 basis points, the rate on 30-year fixed-rate mortgages has risen by 68 basis points, reaching 6.88% in the week ending October 30.

This is related to the subsequent rise in the yields of 10-year and 2-year U.S. Treasury bonds, which determine the long-term rates that consumers pay more directly than the Federal Reserve. The yield on the 10-year U.S. Treasury bond has rebounded to its highest level since July, while the yield on the 2-year U.S. Treasury bond has risen to its highest level since August.

"Some of this is caused by the Federal Reserve itself," McBride said. "A larger rate cut reduces the likelihood of a sharp economic slowdown and increases the chances of continued economic growth. This could slow the progress of inflation."

North indicated that elections may also be part of the equation, as investors react to the potential for either of the two candidates to exacerbate federal debt and deficits. According to estimates from the Committee for a Responsible Federal Budget, Vice President Harris's plan could lead to nearly $4 trillion in debt, while Trump's proposals are expected to expand the deficit by $8 trillion Even including the revenue raised through tariffs.

Experts say that the behavior of the bond market may temporarily prevent the Federal Reserve's interest rate cuts from triggering inflation, but it may also raise concerns among Fed officials, as just about a month ago, they wanted to proactively address the economic slowdown. McBride said:

"This could exacerbate your concerns that the U.S. economy may slow down in the coming months."