Interest Rates Are Likely to Be Cut Until Next Summer as Inflation Threats Fade

The Federal Reserve is expected to lower U.S. interest rates next week, responding to decreasing inflation. This cut is anticipated to be the beginning of a series of rapid reductions that could stimulate economic growth and serve as a safeguard against a potential recession.

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The size of this initial cut remains uncertain ahead of the central bank’s significant meeting on September 17-18. A slight majority of investors currently favor a modest quarter-point reduction over a more substantial half-point cut, according to the CME FedWatch tool. However, most economists argue that the size of the first cut is not the main concern. More critical are the eventual level the Fed aims for and the pace at which it gets there.

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Wall Street has generally converged on the belief that the Federal Reserve will lower its key short-term rate, currently between 5.25% and 5.5%, to as low as 3% by July of next year. Some analysts, like Luke Tilley, the chief economist at Wilmington Trust and a former Fed official, predict an even steeper decline, suggesting the rate could drop to 2.5% in 2025.

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The initial rate cut is expected to be announced on Wednesday, at the conclusion of the Fed’s two-day meeting in Washington. Following this, investors anticipate a series of reductions over the next several meetings, potentially continuing until at least July 2025.

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The Federal Reserve is poised to lower interest rates due to a marked decrease in inflation and a rise in unemployment. With the fight against inflation largely under control, the Fed is keen to avoid pushing the economy into a recession through prolonged high rates. Currently, inflation has slowed to 2.5%, not far from the Fed’s target of 2%. This is a significant drop from its 40-year peak of 7.1% in mid-2022, based on the Fed’s preferred measure, the Personal Consumption Expenditures (PCE) price index.

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Next week, the Federal Reserve is expected to update its forecasts for inflation, U.S. economic growth, interest rates, and unemployment. This update will include the "dot plot," which outlines the projected path of interest rate changes. Back in June, the Fed had anticipated just one rate cut in 2024, followed by four more in 2025. However, this outlook was based on an environment where inflation seemed more threatening, and the labor market appeared robust.

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Since June, economic conditions have shifted significantly. Inflation has eased following a brief uptick earlier in the year, and the labor market has shown signs of cooling. Hiring from June to August was at its lowest level since the pandemic, and the unemployment rate has climbed to a three-year high of 4.2%. The Federal Reserve, tasked with balancing low inflation and high employment, now views the weakening labor market as a more pressing concern than inflation.

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Luke Tilley, who predicts a smaller quarter-point cut, states, "They have absolutely shifted their focus to the labor market." These concerns have fueled expectations of a series of rate cuts, potentially without interruption until next summer: three in 2024 and at least four in 2025.

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Ordinarily, the Federal Reserve prefers to adjust interest rates in small increments, except in crisis situations. Dan North, senior economist at Allianz Trade North America, suggests, "If I am the Fed, I am in no hurry to cut rates. I would opt for 25 basis points and proceed cautiously over the next year or so." North warns that a larger reduction might "send a message of panic" and unsettle the markets.

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Other economists argue that the size of the initial cut will depend on the Fed’s assessment of the labor market’s weakness. While most Fed officials believe the labor market has cooled as expected, there seems to be growing apprehension. In a recent speech, Fed Chair Jerome Powell emphasized the importance of the labor market, pledging to take necessary measures to maintain low unemployment. Some economists, like those at Citibank, believe the Fed's concern may lead to several half-point cuts over the next year.

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Regardless of the size of the initial cut, reduced interest rates are likely to invigorate the economy. High borrowing costs have suppressed home sales, slowed automobile purchases, limited business investments, and caused a downturn in the manufacturing sector. The Fed had aggressively raised interest rates in 2022 and 2023 to combat the worst inflation outbreak since the 1980s. Many economists now believe that inflation could fall to the Fed’s target by early 2025, at least temporarily.

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The PCE price index is expected to reach the Fed's target by January, according to Tilley. Eugenio Aleman, the chief economist of Raymond James, agrees, predicting that "There will be a window next year when inflation will drop below 2%." However, it remains uncertain whether the Fed can maintain this target.

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Economists caution that federal spending remains high, with both presidential candidates proposing new expenditures or tax cuts. Aleman notes, "There are strong tailwinds from the fiscal side," suggesting that government spending will continue to influence the economy. Additionally, reducing interest rates may inadvertently drive up housing demand, potentially reigniting inflation in that sector.

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Despite these concerns, the Federal Reserve is currently focused on achieving a so-called "soft landing"—reducing inflation without triggering a recession. While it is prepared to act aggressively if necessary, it will take time for the effects of lower borrowing costs to permeate the economy. "We looked at the last 50 years," North says. "Usually it takes three to five quarters to boost the economy. So call it a year."

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