With the Fed looming, there is debate about how big the cut will be.

By Howard Schneider

WASHINGTON (Reuters) – The Federal Reserve is almost certain to cut interest rates for the first time in more than four years on Wednesday, marking the beginning of a phase-out of the restrictive measures it has imposed to curb inflation. But whether policymakers will opt for a half-percentage point cut or a smaller step remains unclear.

Their decision on how to initiate a new easing cycle – less than two months before what is expected to be a close US presidential election – is likely to depend more on the signal they want to send after moving away from the highest interest rates in a quarter century than on expectations of the short-term macroeconomic impact, even as their concerns about the labour market grow.

A cut of half a percentage point – which interest rate futures markets now attribute to a probability of over 60 percent – would signal a commitment to maintaining current economic growth and the associated job growth. Fed Chairman Jerome Powell has described this as a top priority as inflation approaches the central bank’s two percent target.

A quarter-percentage point cut in borrowing costs would be more consistent with how the Fed has started previous easing cycles outside of a looming crisis. It would be consistent with the cautious approach central bankers have taken to rate cuts and would be consistent with economic data that show a slowdown but no apparent collapse.

Recent job growth, while down from Covid-19-era highs, remains positive; retail sales and industrial production data released Tuesday beat expectations; and an Atlanta Fed model that tracks economic growth estimates based on incoming data shows the economy growing at an annual rate of 3.0% so far in the third quarter, above the central bank’s estimates of U.S. potential.

“We have never come close to a major turning point in interest rates without more certainty” about what would happen next, Diane Swonk, chief economist at KPMG, wrote on Monday before the start of the Fed’s latest two-day policy meeting. But while a 50 basis point cut “will no doubt be discussed,” Swonk said, “it is unlikely that Powell will get the votes to do it.”

Others argued that after the Fed’s last meeting in July, at one point when several policymakers were open to cutting interest rates and investors were betting on a half-percentage-point cut, less action could be seen as a reneging on Powell’s statement last month that he did not want the labor market to deteriorate further.

“The Fed will make a 50 basis point cut to kickstart the easing cycle and will seek to reassure that it is not lagging and bolster confidence” that the expansion will continue while inflation continues to ease, wrote Krishna Guha, vice president of Evercore ISI, noting that there could be as many as three dissenting votes, an unusual break in Powell’s efforts to operate by consensus.

INFLATION FIGHT

The Fed’s interest rate decision and new policy statement are scheduled to be released at 2 p.m. EDT (6 p.m. GMT), along with updated economic forecasts that will show how much policymakers expect interest rates to fall this year and in 2025. Officials will also update their forecasts for inflation, unemployment and economic growth.

The Fed’s benchmark interest rate has been in the current range of 5.25 percent to 5.50 percent for 14 months. That’s longer than three of the Fed’s last six holding periods, but less than the 15 months in which rates remained unchanged before the 2007-2009 financial crisis, and even less than the 18-month pause during the “Great Dovishness” in the late 1990s.

While the interest rate decision itself is crucial, what may be even more important is how Powell describes that decision and the outlook for borrowing costs during his post-meeting press conference, which is scheduled to begin half an hour after the policy statement and forecasts are released.

The Fed’s decision, the tone of the statement and Powell’s press conference, and the market reaction to it will come about seven weeks before the end of the U.S. presidential election campaign, which could depend at least in part on voters’ perceptions of financial issues such as food and housing costs.

In the wake of the pandemic, a combination of goods shortages, massive government spending, labor shortages, high government deficits and aggressive corporate pricing pushed inflation to a 40-year high in 2022.

While wage growth was also strong, outpacing price increases for many workers, sentiment was depressed much of the time as the Fed raised interest rates in an attempt to slow the economy, mortgage rates rose in response, and banks restricted lending to many types of loans and borrowers.

Inflation, the Fed’s most closely watched measure, is currently about half a percentage point away from the central bank’s target and is expected to gradually decline over the rest of 2024 and next year.

The economy has performed better than expected by almost all measures during this time. Now the Fed is expected to shift into higher gear and provide initial indications on Wednesday of how quickly and to what extent it plans to change course.

(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)