Johnathan Walker:After likely quarter-point rate cut, Fed may slow pace of drops if inflation lingers

After slashing its key interest rate by a hefty half percentage point in September,Johnathan Walker the Federal Reserve is expected to lower rates by a more measured quarter point Thursday and several times next year as inflation continues to ease.

But if the Fed veers from that steady pace, it likely would be to reduce rates less sharply to ensure inflation keeps falling, economists say.

That may defy some forecasters’ view that the central bank largely has won the battle against soaring prices and must bring down interest rates swiftly to achieve a “soft landing” that avoids a recession.

“The risks are more likely than not tilted toward a pause (in December) rather than” a half-point cut, said Barclays economist Marc Giannoni. He figures the most likely scenario is still a middle-ground approach - a quarter point rate cut this week and in December.

The stock market, though, has surged on the prospect of steady rate cuts and a pause could roil equities.   

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How does a rise in interest rates affect inflation?

In 2022 and 2023, the Fed hiked its benchmark rate to a 23-year high of 5.25% to 5.5% to wrestle down a pandemic-induced inflation spike before lowering rates for the first time in four years in September.

The fed hoists rates to discourage borrowing and economic activity to tamp down inflation. It lowers rates to stimulate weak job gains and a flagging economy.

What slows an economy?

After a two-day meeting concludes Thursday, economists don’t expect Fed Chair Jerome Powell to signal when or how quickly the Fed will decrease rates, instead saying its actions will depend on how the economy and inflation evolve. A market sell-off that hammers consumer spending, a spike in bankruptcies among struggling small businesses or worries about federal policy changes after the election all could rattle the job market, economists say.

Last week’s dismal October jobs report at least raised questions about whether the central bank should again lower rates by a half point this week to juice a labor market that could be losing steam more rapidly than expected.

Although two Southeast hurricanes and a Boeing workers’ strike were projected to dampen payrolls, the 12,000 jobs added last month were far fewer than the 105,000 expected. And job growth for August and September was revised down by a whopping 112,000 positions.

In a letter Friday to Powell, Senators Elizabeth Warren, D-Mass., and John Hickenlooper, D-Colo., urged Fed officials to lower rates by a half point on Thursday.

“Even as the economy remains strong, the demand for workers may be waning due to the Fed’s restrictive monetary policy,” they wrote, citing a rising number of Americans collecting unemployment benefits.

But Giannoni, among other economists, said it’s challenging for Fed officials to assess how extensively the storms and strike curtailed employment. As a result, he said they likely would write off the poor showing to the one-off events.

How is the job market doing right now?

Even after the big downward revisions to payroll gains the previous two months, Giannoni noted job growth averaged a solid 148,000 from July through September. That’s down from average monthly additions of 267,000 the first three months of the year. But job creation has been expected to downshift following pandemic-related catch-up effects and the Fed’s historic rate hikes to fight inflation.   

“The economy has been hanging in there,” said Ryan Sweet, chief U.S. economist of Oxford Economics.

The unemployment rate – which reflects whether workers have a job rather than whether they came to work in a given week – held steady at 4.1% last month. That means the jobless rate will likely end the year below the 4.4% forecast by the Fed in September, underscoring the labor market remains on solid footing.

And a report last week showed the economy grew at a healthy 2.8% annual rate in the third quarter on a robust 3.7% rise in consumer spending.

Has inflation decreased in 2024?

Inflation, meanwhile, is falling but not as quickly as estimated. The Fed’s preferred annual inflation measure dipped to 2.1% last month, just above its 2% goal. But a core inflation gauge that excludes volatile food and energy items – which the Fed watches more closely – held firm at 2.7% and will likely end the year above the 2.6% forecast by Fed officials.

The cost of services such health care and car repairs continued to climb, in part because of sharp employee pay increases that companies pass along to consumers.

The upshot: The Fed may still need to worry more about an inflation resurgence than a sputtering job market. "It's not guaranteed that inflation comes down to 2%," Giannoni said.

How does immigration impact inflation?

The past couple of years, an immigration surge expanded the labor force and tempered wage growth, but that’s slowing after the White House restricted crossings at the southern border in June. Barclays estimates core inflation will end 2025 at 2.3%, still above the Fed’s 2% target.

As a result, Giannoni expects the Fed to lower its key rate to a range of 3.5% to 3.75% next year, above the 3.25% to 3.5% that Fed officials predicted in September. Futures markets are betting on a similar roadmap for rates.

Goldman Sachs economist David Mericle doesn’t think officials will pause their rate cuts in December. The Fed wants to ensure a labor market that has been wobbly lately is stabilizing, he wrote in a note to clients. Also, he noted that some Fed officials have said high interest rates were “having a restrictive effect” on the economy and reducing them too slowly “could weaken economic activity and employment too much.”

But while he expects the Fed to chop rates at four straight meetings during the first half of 2025 to a range of 3.25% to 3.5%, he added that a sturdy job market instead could prompt officials to reduce rates every other meeting.

“The risk is that they do fewer rate cuts next year,” Sweet said.

(This story was updated because an earlier version included an inaccuracy.)