Why the Federal Reserve has gambled on a big interest-rate cut

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Subscribe to enjoy similar stories. The Federal Reserve’s decision to lower interest rates by half a percentage point, announced on September 18th, is momentous for two reasons. As the first cut by America’s central bank since it lifted rates to quell inflation, it marks the start of a monetary-easing cycle.

It also represents a bet by the Fed that inflation will soon be yesterday’s problem and that action is needed to support the labour market. For the first time since 2005, one of the Fed’s governors in Washington, DC, dissented from the decision. Michelle Bowman preferred to cut rates by a quarter-point.

When the Fed raised rates between early 2022 and mid-2023, it telegraphed the size of each rise in advance. This time there was uncertainty about how big the reduction would be. A week earlier, market pricing implied roughly 65% odds that the Fed would cut rates by a quarter-point and 35% odds of a half-point.

By the day before the decision, pricing had flipped, indicating a 65% probability of a half-point cut. The fact that some investors, albeit a minority, were still positioned for a smaller move helps explain why stocks rallied at first after the Fed opted for a bigger cut. The argument for a half-point cut rested on several pillars.

Crucially, the Fed is confident that it is on track to bring inflation under control. Price rises have slowed to an annual pace of 2.5%, not far from its target of 2%. With oil prices sagging and rents rising more slowly, there is a good chance that inflation will soon ease further.

So the Fed’s worries have shifted to the job market. The unemployment rate of 4.2% is low, but nearly a full percentage point higher than early last year. And firms have pared back their hiring.