The Federal Reserve is widely anticipated to lower interest rates on Wednesday for the first time in over four years, marking a reversal of its previously restrictive policies aimed at controlling inflation. However, there is still uncertainty over whether policymakers will opt for a half-percentage-point reduction or a smaller cut.

Their decision, coming less than two months before a closely contested U.S. presidential election, is expected to be influenced more by the message they want to convey as they shift from the highest interest rates in 25 years, rather than by short-term macroeconomic concerns. Additionally, the Fed’s growing concerns about the labor market may play a role in the decision.

A half-percentage-point cut, now given a more than 60% probability in futures markets, would underscore the Fed’s commitment to sustaining the ongoing economic expansion and job growth. Fed Chair Jerome Powell has highlighted these priorities, particularly as inflation approaches the 2% target.

In contrast, a quarter-percentage-point cut would align more closely with how the Fed typically begins easing cycles outside of crisis periods. This would reflect the cautious approach previously signaled by policymakers, given that while the economy has slowed, it has not shown signs of an imminent downturn.

Despite slower job growth compared to the post-COVID era, retail sales and industrial production have exceeded expectations. The Atlanta Fed’s model estimates economic growth at an annual rate of 3.0% in the third quarter, well above the Fed’s projections for U.S. potential growth.

Diane Swonk, chief economist at KPMG, noted ahead of the Fed’s meeting that there is rarely this much uncertainty surrounding a major rate decision. She believes that while a 50-basis-point cut will be discussed, Powell may not secure enough votes for it. However, there are also arguments that failing to deliver a larger cut could be seen as inconsistent with Powell’s recent comments that the Fed does not want the labor market to weaken further.

According to Krishna Guha of Evercore ISI, the Fed may opt for a 50-basis-point cut to jump-start the easing cycle and demonstrate that it is not falling behind the curve. However, he expects potential dissent from some policymakers, reflecting divisions within the Fed.

Inflation and Future Projections

Along with the rate decision, the Fed will release updated economic projections covering interest rates, inflation, unemployment, and economic growth. This decision will mark a shift from the 14-month period during which the Fed’s benchmark rate has remained between 5.25%-5.50%. While this rate hold is longer than three of the last six periods of stability, it remains shorter than the 15-month pause before the 2007-2009 financial crisis.

The key focus will be on how Powell frames the rate cut and what signals he provides about the Fed’s future approach to borrowing costs. His remarks, set to begin shortly after the policy statement, are likely to provide insight into the Fed’s strategy for balancing economic growth with inflation control.

As the U.S. heads toward the presidential election, economic issues such as inflation and housing costs are expected to be central to the debate. Post-pandemic inflation surged to a 40-year high in 2022 due to factors such as supply shortages, increased spending, and labor constraints. While wages have grown, many households have faced financial pressure from higher mortgage rates and restricted credit.

Inflation is now around half a percentage point away from the Fed’s target, with expectations for a gradual decline throughout the remainder of 2024. With the Fed’s first rate cut in years likely on Wednesday, the markets will look for clues about how aggressively the central bank plans to shift its policies moving forward.

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