Fed's big cut boosts inflation risk, odds of a policy correction

Anxious about recent cooling in the domestic labor market, the Federal Reserve launched its rate-cutting cycle this week more aggressively than most in financial markets had recently anticipated, boosting the risk of sending inflation higher and potentially limiting just how far the central bank will ultimately lower rates.

The Fed's rate-setting Federal Open Market Committee (FOMC) on Sept. 18 approved cutting its benchmark interest rate by 50 basis points, its first cut since it began hiking rates from near-zero in March 2022 and ultimately pushed them to the highest level in more than two decades.

With equities trading near all-time highs, the economy growing at a rate near 3%, inflation moderating, but still above the Fed’s 2% target and unemployment still near historic lows, there is some concern that the central bank's larger-than-many-expected cut could pose unnecessary risk to a financial system with little apparent stress.

"Did they just overcook it a little bit? Maybe," said Jack McIntyre, a portfolio manager with Brandywine Global, in an interview. "If the economy muddles through and re-accelerates the Fed is going to have to tighten again. That's a real risk."

Fed officials felt that a 50-bp cut, rather than 25 bps, was needed after keeping rates above 5.25% for nearly 14 months, as the US unemployment rate climbed to 4.3% from 3.5% and the central bank's preferred inflation measure falling to 2.6% from 4.2% over that stretch.

"The upside risks to inflation have diminished and the downside risks to employment have increased," Fed Chairman Jerome Powell said during his Sept. 18 press conference, stating the Fed "might well have" cut rates in July if weaker-than-expected jobs data and revisions had been released earlier.

Fed Governor Michelle Bowman was the lone dissenting vote against the 50-bp cut, claiming she preferred a 25-bps cut instead. Bowman is the first Fed governor to vote against an interest rate decision since 2005.

"The economy is doing fine and the move isn't in line with their data-dependent approach," said Oren Klachkin, a financial market economist with Nationwide. "Powell himself characterized the economy as doing okay, so why does it need a 'recession-esque' rate cut?"

Reverse course?

Fed watchers cautioned the 50-bp move could become a policy misstep, one the central bank may need to repair if inflation moves further from that 2% target.

"It's not impossible that the Fed pauses or even reverses course if the economy reaccelerates," said James Camp, managing director of strategic income at Eagle Asset Management.

Camp sees the Fed cutting by another 50 bps before year-end as interest rates settle into a neutral level of between 3.5% and 4% at some point in 2025 as the Fed likely pauses rate moves. The days of significantly lower, near-zero rates are likely over, Camp said.

"The economy is fundamentally different," Camp said. "COVID changed the game."

Fed officials now see their benchmark interest rate falling to 4.4% by year-end, or 50 bps of additional cuts, according to the median view of FOMC officials in the quarterly summary of economic projections released following this week's meeting.

Fed officials also project rates falling to 3.4% by 2025-end, meaning another 100 bps worth of cuts next year, according to the projections. In June, when inflation appeared to be more stubbornly robust, Fed officials forecast their benchmark rate to be 5.1% at 2024-end and 4.1% at 2025-end, although the longer run rate was projected at 2.8%, roughly the same as the 2.9% projected this week.

Fed officials also see inflation falling faster and unemployment rising more this year than they did three months ago, motivating their calls for more cuts through 2025.

While Powell did not downplay these forecasts, as he has done in past meetings, he gave little indication of future rate plans, falling back on his frequent refrain that the central bank's policy moves were data dependent.

"We're going to be making decisions meeting by meeting," Powell said. "We can go quicker if that's appropriate, we can go slower if that's appropriate, we can pause if that's appropriate."

For now, the Fed is focused on limiting the damage in the labor market, even if a 50-bp cut may ultimately prove to be overkill.

"Was the 50 bps necessary? Maybe not, but it's warranted," said Kathy Jones, managing director and chief fixed-income strategist with the Schwab Center for Financial Research. "I think Powell saying the labor market is 'still solid' can be justified by the level of unemployment — but not by the trend in unemployment."