The Fed Just Made a Pivotal Rate Cut. What Will It Do Next?

After the Fed’s pivotal interest rate cut this week, policymakers face the question of how much further to reduce borrowing costs—and how fast.

Fed officials expect to reduce the central bank’s key fed funds rate to a range of 4.25%-4.5% by the end of the year, according to economic projections released this week by the members of the Federal Open Market Committee. That would likely mean quarter-point rate cuts at the Fed’s two final meetings of the year, in contrast to the larger half-point cut that opened the campaign.

But those cuts could end up being deeper if the job market deteriorates. In cutting rates for the first time since 2020, the Fed has signaled it’s paying less attention to fighting inflation and more attention to preserving the labor market. 

Higher Unemployment Could Prompt Deeper Rate Cuts

High interest rates were meant to slow the economy and subdue inflation. Lower ones are supposed to do the opposite, boosting the economy and encouraging businesses to hire to prevent a spike in the unemployment rate. 

That’s why, for anyone trying to predict what the Fed will do, the single most important piece of economic data over the next few months will be the unemployment rate, said Chris Clarke, a professor of economics at Washington State University.

Since January, the unemployment rate has risen to 4.2% as of August, from 3.4% in January, which had tied a 50-year low. The rate, which isn’t high by historical standards, is being driven by an increase in people seeking work and not finding a job rather than a wave of layoffs. Still, it’s risen fast enough to fuel concerns that layoffs could pick up. 

Some Fed watchers believe the cracks in the labor market are severe enough that the Fed will act more decisively to preserve it, especially since their other main concern—inflation—has been tame in recent months, falling toward the Fed’s 2% annual goal. 

Economists Try To Predict What’s Next

Economists at Goldman Sachs predict two 25 basis point (bp) cuts this year, in line with the Fed’s forecasts, but with a good chance of a larger cut in November if upcoming employment reports show slower hiring or rising unemployment. The next two monthly jobs reports, for September and October, will land before the November Fed meeting.

“We see the choice between a 25bp and 50bp cut in November as a close call,” Jan Hatzius, chief economist at the investment bank wrote in a commentary.

Michael Pearce, deputy U.S. economist at Oxford Economics, came to a similar conclusion. 

“Considering the shift toward an easing bias from Federal Reserve officials, any downside surprises to the labor market data could push them to deliver another 50bp cut in November,” he wrote.

More Division Could Be Ahead

Whatever decision the Fed makes, it might be more contentious than some of its past moves. 

The Fed’s moves on rate cuts this week proved tricky enough that one of the policy committee members voted against the other 11, the first dissent since 2022. Fed governor Michelle Bowman explained in a statement Friday why she would have preferred a 25-point cut.

“We have not yet achieved our inflation goal,” she wrote. “I believe that moving at a measured pace toward a more neutral policy stance will ensure further progress in bringing inflation down to our 2% target. This approach would also avoid unnecessarily stoking demand.”