Don't make noise, the magnitude of the first rate cut by the Federal Reserve is irrelevant?

Before the Federal Reserve's key meeting, the size of its first rate cut remains uncertain. According to CME FedWatch data, a minority of investors are betting that the Fed will moderately cut rates by 25 basis points, rather than a significant 50 basis points.

Some analysts, including Luke Tilley, Chief Economist of Wilmington Trust and former Fed official, believe that the Fed's policy rate will further decrease significantly next year to 2.5%.

The Fed is expected to cut rates for the first time at the end of a two-day meeting in Washington on Wednesday. Investors anticipate that the Fed will intermittently cut rates in the next seven meetings at least until July 2025.

With inflation sharply slowing down and unemployment rising, the Fed aims to lower high rates to prevent the economy from entering a recession.

The Fed's battle against inflation has essentially ended. Currently, the inflation rate in the United States has slowed to 2.5%, not far from the Fed's 2% target. According to the Fed's preferred PCE index, inflation is also significantly lower than the 40-year peak of 7.1% in mid-2022.

The Fed's updated forecasts on U.S. inflation, economic growth, interest rates, and unemployment this week may provide a basis for Wall Street's views.

Dot Plot

The most anticipated is the so-called dot plot that depicts the path of rate cuts.

In June, the Fed predicted only one rate cut in 2024 and four more in 2025, but at that time inflation seemed more threatening, and the labor market appeared surprisingly strong.

Since June, there have been significant changes in the economic outlook. After a small surge in inflation earlier this year, it quickly slowed down, while the labor market cooled significantly. The number of hires in the three-month period from June to August dropped to the lowest level since the pandemic began. The unemployment rate has climbed to a three-year high of 4.2%.

Unsurprisingly, the sluggish labor market has surpassed inflation as the Fed's biggest concern. By law, the Fed must maintain stable inflation and maximize employment.

"They have definitely shifted their focus to the labor market," Tilley said, expecting the initial rate cut to be a more moderate 25 basis points.

These concerns have heightened expectations that the Fed will cut rates continuously until the summer of next year: three rate cuts in 2024 and no less than four in 2025 are expected.

Pace of Rate Cuts

Typically, the Fed prefers to make small adjustments to interest rates without a crisis.

"If I were the Fed, I wouldn't rush to cut rates. I would cut by 25 basis points and assess over the next year or so," said Dan North, Senior Economist at Allianz Trade North America. "(Currently) the economic conditions are good."

On the other hand, he believes that a larger rate cut would "send a panic message" and "scare the markets." Other economists say that the size of the Fed's first rate cut may depend on how weak the labor market is.

Most Fed officials have said that the job market has cooled as they expected, but concerns seem to be intensifying.

For example, Powell emphasized the labor market in a major speech a few weeks ago. He vowed that the Fed would take necessary measures to keep the unemployment rate low with unusually tough language.

Citibank economists say that the Fed's anxiety is enough to stimulate rate cuts of at least 50 basis points several times next year.

Economic Conditions

Regardless of the outcome, lower rates will certainly inject a stimulant into the economy.

High borrowing costs have suppressed home sales, restrained car purchases, limited business investment, and plunged manufacturing into a slump.

The Fed is expected to raise rates in 2022 and 2023 to the highest levels since the turn of the century to quell the most severe inflation surge since the 1980s. Before the COVID-19 pandemic, the inflation rate rose by only 1.5% annually.

Many economists believe that inflation may reach the Fed's target in early 2025, at least temporarily, rather than in 2026 as Fed officials predicted in June.

Tilley said, "PCE inflation is expected to reach the Fed's target by January next year."

Raymond James Chief Economist Eugenio Aleman agrees, saying, "There will be a window next year where inflation will drop below 2%."

It is currently unclear whether the Fed can achieve and sustain its inflation target.

Inflation Threat

Economists point out that the federal government is still spending freely, and the tap is unlikely to be turned off soon, which will bet on upward inflation. Both presidential candidates have promised a series of new spending or tax cuts.

"There is strong momentum on the fiscal side," Aleman said. The Fed knows that fiscal tailwinds are still present and will materialize.

Another potential tricky issue for the Fed is high house prices, the biggest source of inflation in recent years.

By lowering rates, the Fed will reduce the cost of obtaining mortgages and stimulate more buyers to enter the market.

However, the surge in demand for new homes could lead to another spike in house prices and increase upward pressure on inflation.

Nevertheless, the Fed is not worried about housing issues at the moment. Officials are focused on achieving a so-called soft landing, lowering inflation without causing an economic recession. If necessary, they are prepared to take proactive action.

However, the magic of lowering borrowing costs will take time to take effect in the economy.

"We have studied the past 50 years," North said, "rate cuts typically take three to five quarters to boost the economy."