US Federal Reserve cuts key interest rates for the first time since Corona

The Fed is getting cold feet. The US central bank is cutting the key interest rate for the first time since 2020, by 0.5 percentage points. The key interest rate range is now 4.75 to 5 percent; monetary policy in the US is still restrictive, but significantly looser than before.

The twelve-member committee headed by Fed Chairman Jerome Powell, which makes the interest rate decision, has given in to pressure from outside. In recent days, voices expecting the Fed to make a larger interest rate cut have become increasingly louder. Former central bank governors have also spoken out in favor of a cut of 0.5 percentage points instead of just 0.25. This despite the fact that Jerome Powell himself had given no indication that the Fed was considering such a step.

The Fed wrote on Wednesday in its statement on the interest rate decision that it has gained greater confidence that the inflation rate will move sustainably towards the 2 percent target. In recent months, the central bank had expressed itself much more cautiously on this point. For the first time in a long time, the Fed also believes that the risks arising from both sides of its mandate are balanced: the risk of higher unemployment on the one hand and the risk of a renewed surge in inflation on the other.

Investors initially reacted with joy to the Fed loosening the reins. The American benchmark index S&P 500 rose immediately after the decision. Long-term American government bonds also initially gained in value, but gave up this gain again during Jerome Powell’s press conference.

A look at the medium to long-term economic forecasts of the 19 leading Fed policymakers dampens the markets’ optimism a little. Almost half of the members surveyed expect that the key interest rate will only be cut by 0.25 percentage points once more by the end of the year, or not at all. The other half expect at least two further cuts of 0.25 percentage points each, i.e. one cut at each of the two remaining meetings in November and December. This means that Fed officials are falling slightly short of the high expectations of the financial market.

The end of uncertainty

Fed Chairman Jerome Powell has been under constant pressure to justify himself in recent weeks. Almost immediately after the last monetary policy decision at the end of July, the public began to discuss whether the central bank was delaying the easing of its monetary policy for too long.

Initial indicators showed that the long-lasting high in the American labor market was coming to an end. At the end of July, Powell said that the Fed did not want to see any further slowdown in the labor market – so some observers became convinced that the Fed was already too late with the first interest rate cut.

However, market participants have rarely been so divided on the outcome of the Fed’s decision. On the day before the decision, according to the CME Group’s popular forecasting tool based on futures contracts, almost two-thirds of market participants expected a cut of 0.5 percentage points. Normally, before a meeting, a large majority agree on what the Fed will do.

There was also great unrest. Whenever there was bad news from the labor market, even if it was just a revision of previous figures, traders reacted sharply and launched new bets that the Fed would start with a double step.

The Fed’s interest rate-setting committee had to weigh up important reasons for both options: There is no question that the American labor market has cooled somewhat in recent months. Because monetary policy always takes effect with a delay, many observers spoke in favor of a sharp reduction of 0.5 percentage points.

The real interest rate – the difference between nominal interest rate and inflation – is more restrictive than it has been for a long time. Because the Fed has been on the brakes for too long, it should now take its foot off the pedal as quickly as possible in order not to stall the economy. The left-wing Nobel Prize winner Paul Krugman even argued in the New York Times on Wednesday that the Fed should quickly go above 0.5 percentage points.

At the press conference on Wednesday, however, Powell made it clear that the Fed does not believe it reacted too late to the cooling labor market. “But we are sending a signal that we do not want to fall behind.”

The other camp, however, stressed that core inflation – that is, inflation excluding volatile food and gasoline prices – is still well above the Fed’s 2 percent target. Inflation could therefore return quickly if the central bank declares the fight against inflation over too early.

Although the Fed did not comply with the wishes of these monetary policy “hawks” this time, Jerome Powell also addressed their concerns at the press conference. He gave a useful definition of what price stability means: “when people no longer think about inflation in their everyday decisions.” Powell made it clear that the Fed does not yet believe that it has won the battle against inflation. But it has come closer to the goal.