The Fed Rate Cut: Usual Measure for Unusual Times?

By Rodney Sullivan, executive director of the Mayo Center of Asset Management at the Darden School of Business (University of Virginia)

On Wednesday, September 18, for the first time since the spring of 2020, and after a historic rise that began in 2022, the Federal Reserve lowered its key interest rate by 0.5 percentage points. The central bank is also considering an additional half-point cut by the end of 2024. This marks the start of a new monetary policy easing cycle. The 0.5 percentage point cut is clearly intended to stimulate the economy and significantly reduces, though does not eliminate, the risk of a hard economic landing over the next year. 

According to Federal Reserve Chairman Jerome Powell, the Fed's current focus is on maintaining the unemployment rate at its relatively low level of around 4.3 percent. Despite concerns about an employment-led recession induced by previous tighter monetary policy, such a downturn has yet to materialise. Unemployment trends continue to outperform expectations, showing resilience. To help ensure this stability continues, the Federal Open Market Committee (FOMC), in its updated Summary of Economic Projections (SEP), has signalled the possibility of one or two more rate cuts this year, with another 100 basis points of cuts expected next year.

Inflationary pressure

US inflation is currently hovering around 3%. This new monetary easing cycle signals the end of the Federal Reserve’s tightening phase, which began in March 2022 to bring inflation down to the Fed’s 2% target. Chair Jerome Powell has emphasised that restrictive monetary policy helped restore balance to the economy, aligning with the Fed’s dual mandate of maximum employment and stable inflation. Now, he is confident that the current strength in the labour market can be sustained as inflation continues to decline toward the 2% goal. In other words, the Federal Open Market Committee (FOMC) believes its policy is well-positioned to address both sides of its mandate.

Inflation began exceeding the Fed’s target in early 2021, peaking at around 9% by mid-2022. In response, the Fed rapidly raised interest rates to curb inflation. While some have criticised the Fed for acting too slowly, the tightening measures have proven effective. Inflation has been steadily declining since the 2022 peak, and the Consumer Price Index (CPI) now places inflation at just under 3%. Although inflation remains above the Fed’s 2% target, the Fed maintains that inflation expectations are well-anchored and on track to reach the goal. The FOMC’s latest Summary of Economic Projections (SEP) forecasts an inflation rate of 2.3% for this year, falling to 2.1% by 2025.

There are concerns the Fed’s 50-basis point rate cut could reignite inflation, but the central bank is cautiously balancing this risk against the potential for economic weakness. As always, any decision to raise, lower or hold interest rates carries inherent economic uncertainty.

Ultimately, the true impact of this easing cycle will become clearer in the months ahead, as the Fed continues its effort to support both sides of its dual mandate.

Usual measure for unusual economic circumstances?

The Fed’s 0.50 percentage point cut is a typical move at the start of a new monetary easing cycle. However, this time, the economic circumstances are different. Powell has emphasised the cut is not a response to economic weakness but rather a recalibration of monetary policy to better balance the risks of inflation and economic slowdown. Unlike previous easing cycles, where the Fed responded to clear financial crises driving recessions, this cycle is more pre-emptive, aimed at preventing a potential recession before it fully develops. Fed officials are more concerned about recession risks now, having become less worried about inflation compared to the past two and a half years.

The US labor market is showing signs of cooling compared to earlier this year. While the unemployment rate has edged up in recent months, it remains low by historical standards, and there has been no sharp increase in layoffs. Job creation has slowed somewhat, but labor market conditions are less tight than last year, with employment and hiring still relatively strong.

So, where does that leave the US economy?

A key measure of economic activity is the growth rate of real gross domestic product (GDP). The Atlanta Fed’s GDPNow model, which provides a "nowcast" of current economic conditions, estimates real GDP growth at just under 3% for the third quarter of 2024—similar to the second quarter but up from 1.4% in the first quarter. A recession is typically defined as two consecutive quarters of negative GDP growth.

However, the Federal Open Market Committee (FOMC) expects real GDP to grow by around 2% this year and over the next two. While this outlook isn’t considered particularly strong, it also doesn’t align with the conditions typically associated with a recession.

So, in conclusion, while the US economy is not experiencing robust growth, current indicators such as real GDP and employment conditions suggest it remains resilient. Despite concerns over a potential recession, the outlook points to steady, moderate growth. With inflation currently contained, the Fed's policies currently favor maintaining a strong employment picture over its prior focus on bringing inflation under control.