The Federal Reserve expects another rate cut

WASHINGTON — No one knows how Tuesday’s presidential election will play out, but the Federal Reserve’s actions two days later are much easier to predict: As inflation continues to fall, the Fed is set to cut interest rates for the second time this year.

The presidential dispute may still remain unresolved when the Fed concludes its two-day meeting Thursday afternoon, but that uncertainty will not affect its decision to cut its benchmark rate further. However, the Fed’s future actions will become even more volatile when a new president and Congress take office in January, especially if Donald Trump wins the White House again.

Trump’s proposals to impose high tariffs on all imports and begin mass deportations of illegal immigrants, as well as his threat to interfere with the Fed’s usually independent rate decisions, could lead to a sharp rise in inflation, economists say. Higher inflation, in turn, will force the Fed to slow or stop cutting rates.

On Thursday, Fed policymakers led by Chairman Jerome Powell are set to cut its benchmark rate by a quarter point to about 4.6%, following a half-point cut in September. Economists expect another quarter-point rate cut in December and possibly additional similar steps next year. Over time, lower rates tend to lower the cost of borrowing for consumers and businesses.

The Fed cuts rates for a different reason than usual: It often cuts rates to support a sluggish economy and weak labor market, encouraging more borrowing and spending. But the economy is growing quickly and the unemployment rate is low at 4.1%, the government said Friday, even as hurricanes and a Boeing strike sharply reduced net job growth last month.

Instead, the central bank is cutting rates as part of what Powell called a “recalibration” for an environment of lower inflation. When inflation surged to a four-decade high of 9.1% in June 2022, the Fed proceeded to raise rates 11 times, eventually bringing its key rate to about 5.3%, also the highest in four decades.

But annualized inflation fell to 2.4% in September, barely above the Fed’s 2% target and equal to 2018 levels. With inflation so far down, Powell and other Fed officials have said they believe high borrowing rates are no longer necessary. High borrowing rates tend to limit growth, especially in interest rate-sensitive sectors such as homebuilding and auto sales.

“The cap was put in place because inflation was elevated,” said Claudia Sahm, chief economist at New Century Advisors and a former Fed economist. “Inflation is no longer elevated. The reason for the restriction has disappeared.”

Fed officials suggested that the rate cut would be gradual. But almost all of them expressed support for some further cuts.

“For me, the central question is how much and how quickly to cut the Fed’s target rate, which in my view is currently set at a restrictive level,” Christopher Waller, an influential member of the Fed’s board of directors, said in a speech last month.

Jonathan Pingle, an economist at Swiss bank UBS, said Waller’s language reflected “extraordinary confidence and conviction that rates will fall.”

Next year, the Fed will likely begin to wrestle with the question of how low its benchmark rate should go. Ultimately, they may want to set it at a level that neither restricts nor encourages growth—”neutral” in Fed parlance.

Powell and other Fed officials admit they don’t know exactly where the neutral rate is. In September, the Fed’s rate-setting committee estimated the figure at 2.9%. Most economists estimate it to be between 3% and 3.5%.

The Fed chairman said officials need to evaluate the neutrality of how the economy responds to rate cuts. At the moment, most officials are confident that the current Fed rate of 4.9% is much higher than neutral.

But some economists argue that because the economy looks healthy even with high borrowing rates, the Fed doesn’t need to ease lending much, if at all. The idea is that they may already be close to a level of interest rates that does not slow down or stimulate the economy.

“If the unemployment rate stays at 4% and the economy continues to grow at 3%, does it matter that the (Fed) rate is between 4.75% and 5%?” asked Joe LaVorgna, chief economist at SMBC Nikko Securities. “Why are they cutting now?”

With the Fed’s final meeting coming just after Election Day, Powell will likely field questions at his Thursday news conference about the outcome of the presidential race and how it could affect the economy and inflation. You can expect him to reiterate that the Fed’s decisions are not influenced by policy at all.

During Trump’s presidency, he imposed tariffs on washing machines, solar panels, steel and a range of goods from China, which President Joe Biden supported. While research shows that washing machine prices have risen as a result, overall inflation has risen only slightly.

But Trump is now proposing significantly broader tariffs—essentially taxes on imports—that would raise prices by about 10 times on many goods from abroad.

Many leading economists are alarmed by Trump’s latest proposed tariffs, which they say will almost certainly reignite inflation. A report from the Peterson Institute for International Economics concluded that Trump’s major tariff proposals would cause inflation next year to be 2 percentage points higher than it would otherwise be.

The Fed is more likely to raise rates this time in response to the tariffs, “given Trump is threatening much larger tariff hikes,” according to economists at Pantheon Macro Economics.

“Accordingly,” they wrote, “we will reduce the funds rate cut in our 2025 forecasts if Trump wins.”

Originally published: November 3, 2024 3:53 pm EST