What if the Fed cuts interest rates by half a point?

The Fed’s target for the federal funds rate is now in a range of 5.25%-5.50% – a level generally considered restrictive for the economy. Investors and analysts widely agree that a cut is coming in September as the Fed seeks to make interest rates neither stimulative nor restrictive. But with recent evidence of the labor market cooling more than expected, observers are divided on how quickly those cuts will come and how deep they will be.

As of Friday, markets are leaning toward the Fed with a small cut of a quarter point, followed by further cuts through the rest of the year and into 2025. “How quickly do you want to get there? That’s the debate,” says Don Rissmiller, chief economist at Strategas. While the Fed’s default move would normally consist of regular tapering in shallow increments, he explains, evidence of cracks in the labor market changed the picture for investors last week.

Bearish Jobs Reports Raise Fears of Economic Slowdown

With inflationary pressures easing after two years, central bankers have been preparing for months to ease policy for the first time since the pandemic began. The conversation took on new urgency in July and August, when data showing the U.S. economy added fewer jobs than expected raised fears among some investors that too tight a monetary policy was hurting the labor market.

For investors, there’s a big difference between the Fed steering the economy toward a comfortable landing and reacting to the threat of a recession. If officials are concerned that the economy may be in a downturn, they are more likely to cut rates faster and deeper.

Why would the Fed cut rates by 50 basis points?

As investors wondered whether the Fed hurt the labor market by waiting too long to ease policy, speculation about a 50-basis-point cut in the key rate grew.

Some market watchers argue that the central bank has already waited too long and should start cutting interest rates aggressively to prevent the labor market from entering more dangerous territory. “When you start seeing small cracks, they can turn into big cracks if you don’t do anything different,” explains Rissmiller. He believes the Fed should and will opt for the 50 basis point cut. “I think they’re behind the curve here,” he says, though he notes that the decision will ultimately be “a close call” because the FOMC did not agree to the move before the lockout period at the September meeting began. He believes Fed Chairman Jerome Powell should lead the charge for more tapering.

Rissmiller believes there’s also a case for “front-loading” discounts. With policy at such a restrictive level, the Fed has a lot of room to maneuver. The central bank “has the greatest ability to move in larger increments now and not overshoot,” he says. Larger downward policy moves are riskier because Fed policy appears in the economy with a lag and would make it easier for the Fed to overcorrect and take rates too low. He also believes that a larger rate cut now would protect the economy if the labor market is even weaker than it appears — which is possible given the recent downward trend in employment data.

The risks of a 50 basis point cut

A bigger rate cut to kick off the Fed’s easing cycle would also come with risks, especially since financial markets are highly sensitive to any perceived guidance from the central bank. “If the Fed were to cut 50 basis points in September, we think markets would see that as an admission that they are behind the curve,” Bank of America analysts wrote in a research note last week.

The markets wouldn’t be out of alignment to worry about. Data recently analyzed by UBS shows that since 1987, every 50 basis point rate cut has preceded a recession. But their economists note that those cuts coincided with much more economic weakness than they see today, and they argue that means the bar for a 50 basis point cut remains quite high.

Rissmiller isn’t as concerned about messaging to the market: “The Fed has a lot of communication tools. It’s going to be a press conference, so I think it’s a minor risk.” He believes the risk of a market backlash should not dissuade Fed officials from tapering more “if they conclude it is the right thing to do.”

Investors are leaning toward a 25 basis point cut

Expectations for the scope of the first cut have been mixed as traders struggle to digest mixed economic data. A month ago, bond traders saw a 53 percent chance the Fed would cut rates by 50 basis points, according to CME’s FedWatch tool. A week ago, that probability dropped to 30 percent, and then even lower after a positive August inflation report.

As of midday Friday, bond futures were priced with a 45 percent chance of a bigger discount and a 55 percent chance of a smaller discount.

Bigger cuts could come later

Even if the Fed opts for a quarter-point rate cut at its next meeting, analysts say the door is still open for more cuts later this year. The Fed has repeatedly stressed that it will take into account ongoing economic data when setting policy rather than following a prescribed path, and analysts expect it to maintain that position.

“The broad measures we’re looking at for the labor market suggest there’s a real possibility the Fed will accelerate the pace of rate cuts in November or December,” said Kathy Bostjancic, chief economist at Nationwide Mutual.

Reacting to recent comments from Fed officials, Goldman Sachs economists say they expect a 25 basis point cut at the September meeting. However, they add that Fed leadership appears to be “open to 50 basis point cuts at subsequent meetings if the labor market continues to deteriorate.”

Investors should keep the long-term in mind, but prepare for opportunities

Amid that uncertainty, Scott Wren, senior global equity strategist for Wells Fargo Investment Institute, says long-term investors shouldn’t get too hung up on the details. “For retail investors trying to build wealth over time, the important thing is that the Fed will begin a series of tapering,” he says. “A quarter point here or there is like splitting hairs. The important thing is that the rates are going down.”

Wren expects the Fed’s easier policy to boost economic growth, but warns that markets could be choppy in the shorter term as investors adjust to a new cycle. This could represent a short-term opportunity for investors with cash on the sidelines. “As hard as it is for retail investors, they should take these pullbacks if their horizon is over three, over five years, because then they can buy stocks when they’re down,” he says.