The Federal Reserve’s rate-setting body cut its policy rate target band by half of a percentage point, from 5.25–5.50% to 4.75–5.00% on Wednesday, September 18. This widely anticipated move lowered the Fed’s rate target for the first time since March 2020, when emergency rate cuts were implemented in response to pandemic-induced shutdowns.
The federal funds rate target band had been on hold since July 2023, which marked the end of the rapid hiking cycle initiated in March 2022 in response to high inflation as the global economy re-opened, demand surged, and supply chains revived.
Columbia Business School Professor Brett House and teaching assistant Robert Swigert, EMBA ’23, offered insight into the rationale for the Fed’s interest-rate move, possible implications for households and markets, and what’s next in monetary policy.
What economic factors drove the Fed's decision to cut rates?
Fed Chair Jerome Powell signaled clearly in his Jackson Hole speech on August 23 that he intended to lead the Federal Open Markets Committee (FOMC) in implementing a rate cut at the September meeting. The only open question was how large this cut would be: a quarter of a percentage point or a half-point — that is, 25 or 50 basis points, in market parlance. Doubt stemmed, in part, from what appeared to be mixed signals and differing views among members of the committee.
Chair Powell and the FOMC were set for a cut because both price pressures and labor markets have cooled substantially compared with two years ago. The headline Consumer Price Index (CPI) came down from 3.2% year over year (y/y) a year ago to 2.5% y/y in August, mirroring the 2.5% y/y inflation rate recorded in the Fed’s preferred benchmark, the Personal Consumption Expenditures (PCE), in July. The unemployment rate rose from a low of 3.4% in April 2023 to 4.2% in August — with part of the rise driven by increased immigrant numbers rather than layoffs. Still, new hiring has slowed, job openings are down, and savings rates have fallen as consumers have dipped into their reserves and borrowed to sustain their spending — all of which points to further softness ahead.
Given that monetary policy takes between one and two years to have its full impact, policymakers are acting decisively now with a 50 basis points cut to ensure economic activity doesn’t slow further and take the United States past a soft landing and a recession. Nevertheless, the FOMC’s statement showed some equivocation: The committee noted that its employment and inflation targets were already “roughly in balance” but that inflation was still “elevated” — and yet the FOMC cut by 50 basis points rather than 25. Fed officials may be more worried about growth and labor markets than they’re saying.
Additionally, we are only 15 months removed from the failures of Silicon Valley Bank, First Republic Bank, and Signature Bank. The Fed has an “unofficial” mandate to ensure the stability of the financial system, and a high interest-rate environment increases the likelihood of financial stress. Rate-sensitive sectors such as commercial real estate and regional banks carry potential tail risks to the financial system that this rate cut mitigates.
How might a rate cut impact consumer spending and borrowing in the short term?
Real borrowing costs are determined by nominal interest rates less the rate of inflation. As policy rates have been on hold over the past year and inflation has come down, real interest rates have risen to over 3% and remain high — well above the 0.5% to 1.5% range that the New York Fed estimates would be neither stimulative or restrictive to economic activity.
The Fed’s half-point initial cut doesn’t do much to change real rates in the short term, even with its immediate impact on variable-rate debt products, such as credit cards, home-equity credit lines, adjustable-rate mortgages, and some business loans, but the FOMC’s signals that further cuts are coming will loosen financial conditions. Market pricing has already predicted these cuts, bringing down yields on US Treasuries, which serve as the benchmarks for new mortgages and car loans. New student loans are contracted on a reference rate that was set in July, so they won’t see a relief this year from the Fed’s move.
Overall, the rate cut creates a little more breathing room in household budgets, but with prices still high and labor markets weakening, it’s unlikely to set off a surge in consumer spending. Still, the rate cut should help sustain demand.
What are the potential risks and benefits of a rate cut for the broader US economy?
The Fed faces two-sided risks as it begins to ease the cost of borrowing.
If the Fed cuts too slowly, current downward momentum in labor markets and prices could accelerate and push the US economy into a hard landing with substantial pain for households and businesses. There are already signs of stress, as overdue payments have risen on a range of consumer credit products. Also, demand is flagging in the rest of the world’s major economies: growth has softened in China, the UK, Europe, and Canada. This is why the Fed chose to cut by half of a percentage point rather than a quarter-point.
On the other hand, if the Fed cuts too quickly, its hard work to tame inflation could be partially undone. Lower rates could ignite more borrowing and fresh price increases in consumer goods, services, and housing markets; already richly priced equity markets could become even more stretched and vulnerable to a sharp correction; and upturns in oil and other commodity prices, particularly if geopolitical conflicts intensify, could stymie further declines in inflation.
With the US election looming in November, some caution by policymakers is called for: An extension or increase in tariffs by a new White House administration and Congress would boost prices and hurt growth. With that possibility in mind, the Fed’s projection of a series of gradual further rate cuts — not more half-point steps — is prudent.
How could the rate cut affect global markets and the value of the US dollar?
The Fed’s move was already widely expected by equity, fixed-income, and currency markets. While there was an immediate shift in rates and exchange-rate pricing in response to the move, the Fed’s broader message that further cuts are coming gradually is going to dominate analysts’ and traders’ narratives and investment decisions. After heightened volatility during August and early September in response to data that put the outlook for the US economy and monetary policy in greater doubt, the path ahead now looks clearer.
The US dollar isn’t likely to suffer much as the Fed eases, since most other major central banks are also cutting their key policy rates. Still, the dollar is likely to weaken gradually as market stress remains low, which will dampen safe-haven flows into the greenback and US growth cools in line with other economies.
What are the key indicators the Fed will monitor after the rate cut to evaluate its effectiveness?
As always, the Fed will remain focused on the key indicators related to its mandate to “promote the goals of maximum employment, stable prices, and moderate long-term interest rates.” Since August 2020, stable prices have been defined as inflation at 2% y/y on average over time. The 2020 shift from a point target of 2% y/y to an average target implies that the Fed is now slightly — but only slightly — more willing to look through blips above 2% y/y to preserve the labor market gains of the past few years. It will continue looking for signs of any stickiness in the inflation numbers, hints that the labor market is set to materially worsen, and leading indicators that the still-healthy US economy is slowing more than currently projected.
