US key interest rate falls, but how much?

He can’t please everyone: Fed Chairman Jerome Powell and his eleven colleagues on the Federal Open Market Committee (FOMC) are facing the most difficult and momentous monetary policy decision in a long time. And opinions on what the US central bank should decide on Wednesday are widely divided.

Luxury chauffeur in distress

The Fed will cut the key interest rate on Wednesday – for the first time since the outbreak of the corona pandemic in 2020. Nobody doubts that. Inflation is significantly lower and unemployment is slightly higher than at the beginning of the year. There is no reason for the Fed to wait any longer, especially since the monetary authorities in the euro area, Switzerland, Canada and Great Britain have already started cutting rates.

However, the Fed is at the center of a lively debate about whether interest rates should be cut by 0.5 percentage points. It would be an unusual step that the Fed would otherwise only consider on the brink of a recession and would be reluctant to do. You have to imagine Powell as a high-class chauffeur who drives the US economy through heavy traffic: he drives with such foresight, brakes and accelerates so carefully that his passengers in the back seat should not feel any jolting.

Powell’s problem: Traffic often doesn’t play along. Because the key interest rate always has a delayed effect on economic activity, the Fed is constantly in danger of reacting too late to economic changes. This happened in 2022, when the central bank reacted too late to a surge in inflation.

The price of oil, for example, is difficult to predict, as it will affect a whole range of other prices in the medium term. The price of a barrel of Brent has fallen from over 90 to 70 dollars within a year – a welcome support for the Fed’s fight against rising prices. In 2022, due to the outbreak of the war in Ukraine, oil cost more than 120 dollars per barrel at times, thus driving up inflation sharply. Even now, wars, a naval blockade in the Red Sea or a surprising economic recovery in Europe or China could quickly push the price of oil up again and cause a new surge in inflation.

The pressure on the Fed is increasing

This permanent uncertainty also explains why opinions diverge so much as to the extent to which the Fed should loosen its monetary policy. Proponents of a double-step approach argue that monetary conditions are currently extremely restrictive: Because inflation has fallen rapidly, the real interest rate is currently at a high 3 percent.

There is no longer any reason for such harshness, on the contrary. The weakening labor market calls for a neutral, if not even loose, monetary policy. The Fed should have decided on the first cut in July, say the critics. Since it missed this point, it is appropriate to reduce the shortfall with a double step.

Opponents argue that inflation could flare up again if the Fed prematurely declares victory over inflation and eases interest rates too much. The core rate of inflation, which excludes volatile elements such as food and gasoline, remains at over 3 percent. Housing costs in particular continue to rise sharply, both for renters and home buyers.

The US economy is still healthy and not at all on the verge of a recession, argues the “hawk” camp, which does not want to loosen monetary policy too much. The Atlanta Fed’s widely followed real-time indicator currently shows economic growth of 2.5 percent for the US; annual wage growth was still 4.6 percent recently.

In general, it is not important whether the Fed starts with a single or double step. What is crucial is the destination of the journey – and that it actually begins in September.

The warnings are getting louder again

Until last week, it seemed almost certain that the brakes would have the upper hand. But over the weekend, important voices, including Bill Dudley, the former president of the influential Federal Reserve Bank of New York, and the editorial board of the Wall Street Journal, spoke out strongly in favor of a sharp reduction.

Bond and equity investors have reacted to the new tone. Two thirds are now expecting a large reduction of 0.5 percentage points; at times last week, this was only a small minority.

Sometimes investors have a wish that the prices on the US stock exchanges would benefit from a significant reduction in interest rates. Low interest rates are particularly helpful for companies that need a lot of outside capital and can now borrow money more cheaply. But some companies in the tech sector also benefit from low interest rates because their value is based primarily on future profits.

The Fed’s interest rate decision has consequences beyond the USA. A double step would further weaken the dollar, which in turn would pose challenges for important partners such as Japan. The yen recently climbed to its highest level against the dollar in a long time.

A similar situation caused investors to panic a month ago and caused them to quickly unwind bets financed with yen. The American tech sector was one of those affected. The result: The Nikkei collapsed temporarily, but so did the prices of important US companies such as Nvidia. The Bank of Japan will make its next interest rate decision on Friday.

In recent weeks, the stock markets in Japan and the USA have recovered. But professional taxi driver Powell would prefer to be able to carry out his next interest rate maneuver without any hiccups.

In the shadow of the elections

One final unknown is politics. Donald Trump, the Republican presidential candidate, has recently repeatedly called on the Fed to refrain from cutting interest rates in the run-up to the elections. Trump is normally a friend of low interest rates. But because these could currently help the Democratic government, Trump sees this as an undue interference by the central bank in politics.

Some analysts wonder whether the Fed will only decide on a small rate cut in this situation in order to offer less scope for criticism from Trump. But it is very unlikely that Powell and the other governors will allow themselves to be influenced by the rhetoric of a presidential candidate.

It is to be expected that the Fed leadership will ignore Trump’s “warning,” as it generally does with requests and suggestions from politicians.

But the discussion alone shows that a lot is at stake when Fed officials meet this Tuesday and Wednesday to make their interest rate decision. In this respect, it will not just be the amount of the cut that will be of interest, but also the words Powell will use to justify the decision. Powell could use the press conference to somewhat weaken the stimulating effect of a double step. If the Fed only decides on a cut of 0.25 percentage points, Powell could, however, confirm that they are prepared to make sharper cuts if the economic situation worsens.

The Fed will also publish the economic forecasts of the FOMC members. These often give the market a rough indication of how the Fed’s monetary policy will develop if no shocks hit the US economy.