Key takeaways from the Fed’s decision to massively cut interest rates

Washington
CNN
—

The Federal Reserve cut interest rates sharply on Wednesday, announcing the first rate cut since March 2020.

The half-percentage point change paves the way for lower borrowing costs across everything from mortgages to credit cards.

This is a crucial milestone in the central bank's historic fight against inflation, which has kept interest rates at a 23-year high for over a year. President Joe Biden acknowledged the Fed's success at such a critical moment, saying in a statement on X that “we have just reached an important moment.” Meanwhile, stock prices fluctuated after the decision was announced.

The non-unanimous decision to cut the benchmark interest rate by half a percentage point signals to the world that central bankers are in a hurry to quickly relieve the US economy of high borrowing costs. In recent days, there have been loud calls for the Fed to start its rate-cutting cycle with a bang.

Nevertheless, Fed Chairman Jerome Powell said in a press conference that the central bank was “not lagging behind” and that the Fed's decision to cut interest rates by half a percentage point was “a sign of our determination” not to fall behind in responding to economic reality.

Fed Governor Michelle Bowman, who has frequently expressed concern about ongoing price pressures, was the only one to oppose the move, supporting a quarter-percentage-point cut instead. This was the first dissenting opinion by a Fed governor since 2005.

In their latest economic forecasts, Fed officials also planned for further rate cuts by the end of the year, compared to the only cut in 2024 that they forecast in June. Central bankers also expect unemployment to rise even further this year, rising to 4.4%, compared to the current rate of 4.2% in August.

Despite the Fed's aggressive approach on Wednesday, the central bank's fight against inflation seems to be paying off so far, despite immense pressure from Wall Street and politicians: Inflation is well below the 40-year high of summer 2022 – and that without a recession. The enormous progress made since then is due not only to higher interest rates, but also to the gradual recovery of the US economy from the severe disruptions caused by the pandemic.

The Fed has actually managed to tame price pressures without sacrificing the American labor market, an extremely difficult task because interest rate hikes intentionally cool the economy. The tool used by the Fed is usually described as a sledgehammer, not a scalpel.

Despite declining inflation, there are still fears, mostly about the future of the labor market rather than the possibility of inflation stagnating or resurging. This is precisely why some have called for the Fed to begin aggressive rate cuts. The unemployment rate has risen relatively quickly over the past year, but from unusually low levels. Economists have generally stated that once unemployment starts to rise, it tends to gain momentum and continue to rise.

This puts a possible soft landing of the US economy at risk – a scenario in which inflation is contained without unemployment rising sharply. Such an outcome has only occurred once in modern history, in the mid-1990s. The Fed is therefore within touching distance of a historic success.

Here are the key takeaways from the Fed’s latest interest rate decision.

The Fed was under pressure to begin cutting interest rates in July, but did not do so.

Some investors and economists pointed to rising unemployment and how the labor market can sometimes deteriorate in a moment. The central bank is still waiting for enough evidence that inflation has been brought under control, but Powell had said a weakening labor market could hasten the timing of the first rate cut.

The pace of the labor market slowdown appears to have been the deciding factor. But it also raises the question: should the Fed have cut rates in July? Clearly, some investors believe the Fed is lagging behind, and the decision to cut rates by half a percentage point has fueled that pressure even further. It's a tricky situation for the Fed, and even the fact that the decision was not unanimous casts even more doubt on the soundness of its decisions.

Powell disagrees with this view. He said the Fed is simply committed to maintaining the strength of the labor market. That is, central bankers are not trying to put out a fire, but rather to design an insurance policy with their rate cuts. This explanation could appease Wall Street.

“When will investors believe the Fed is getting ahead of the curve and proactively exercising its put option? That's the most important question because investors have been implicitly asking it all summer – and hoping for this outcome,” Jason Draho, head of asset allocation, CIO Americas, at UBS Financial Services, said in a recent analyst note. He added that the Fed's commitment to continuing to grow the U.S. economy is critical to investor confidence.

Powell also said that further massive cuts were not necessarily on the horizon, suggesting that the Fed may not be able to catch up. He said: “I don't think anyone should look at this and say, 'This is the new pace.'”

The Fed chief clearly expressed his optimism about the overall US economy and its prospects, including the labor market.

“The labor market is in solid shape and our policy move today is to keep it that way,” Powell said. “That can be said about the economy as a whole: The U.S. economy is in good shape. It is growing at a solid pace, inflation is declining. The labor market is at a strong level. We want to keep it that way. And that's what we're doing.”

His characterization is consistent with the numbers. Employers have continued to add jobs at a healthy pace and unemployment remains at historic lows despite recent slowing momentum. Powell warned, however, that the labor market is no longer where it was “on the eve of the pandemic,” as he had previously said, but that it is “less tight now” than it was at the end of 2019.

The Fed chief stressed that central bankers must perform a difficult balancing act if they want to keep inflation under control on the one hand and prevent a deterioration in the labor market situation that is difficult to remedy on the other.

Powell is often asked whether the Fed's decision is politically motivated, especially with the upcoming U.S. presidential election. His answer is usually that the Fed is a non-political institution that makes its decisions based on economic data.

Former President Donald Trump has said he would not reappoint Powell if re-elected – and would even push for more say in monetary policy. Powell, in response to a question from CNN's Matt Egan, said such a change would negatively impact the soundness of the Fed's decisions.

“Democracies around the world, countries like the United States, have independent central banks. And the reason for that is because people have found over time that isolating the central bank from direct control by political authorities avoids creating monetary policy that potentially favors those in office over those out of office,” Powell said.

“We do our work to serve all Americans. We serve no politician, no political figure, no cause, no issue, nothing. It's all about maximum employment and price stability on behalf of all Americans.”