The Federal Reserve’s Jumbo Rate Cut Comes With a Big Risk

The Federal Reserve’s much-anticipated interest rate-cutting campaign started with a bang after Jerome Powell and the Federal Open Market Committee (FOMC) elected to lower the target range of the benchmark federal funds rate by a half-point, much to the market’s delight.

After an aggressive rate-hiking campaign over the last few years, the market has been waiting for the Fed to cut, a scenario that typically favors equities. That might explain why the stock market has been hitting fresh highs all year. But while investors were pleased, the Fed’s jumbo rate cut comes with a big risk. Let’s take a look.

Reigniting inflation

The Fed’s dual mandate includes controlling prices (inflation) and maintaining stability in the labor market. Over the past few years, unemployment has been at historic lows, while inflation hit a four-decade high at one point. The Fed embarked on an aggressive rate-hiking campaign to rein in inflation and moderate the red-hot economy.

So far, the Fed has done a pretty good job, bringing down the headline inflation number to 2.5% in August, trending toward the Fed’s 2% target, while unemployment has risen to 4.2%. The Fed is trying to engineer a soft landing, in which inflation comes down and high interest rates don’t tip the economy into a recession.

However, the 50-basis-point cut reflects the Fed’s decision to turn its attention to the labor market amid concerns that unemployment may start to rise more than the Fed would like. Recently, the three-year monthly average of unemployment rose more than 0.5% above the low three-month average of unemployment within the last year — triggering the “Sahm rule,” which has a good history of signaling a recession.

On one hand, it makes sense for the Fed to focus on the labor market. But on the other, the risk is that the Fed may have lowered rates too soon, which could reignite inflation.

In his press conference following the FOMC’s rate cut, Powell acknowledged that the committee is not declaring victory over inflation and said the goal is to get inflation down to 2% and keep it there for “some time.” Despite rising unemployment, it’s hard to say that the economy is in a bad place. U.S. retail sales in August just rose 0.1% from July, coming in well ahead of expectations. Meanwhile, shelter costs, such as housing, have been rising 40 basis points per month basically all year long. In August, shelter prices rose 50 basis points from July.

Rate cuts are intended to stimulate the economy. So, what if a big 50 basis points does just that? Lower interest rates can increase demand for borrowing because the cost of debt is lower. Housing inventory also remains tight because many are clinging to homes they purchased during the pandemic at interest rates under 3%. Many experts believe mortgage rates would have to fall further to get this cohort of buyers interested in selling, which would finally add some supply to the housing market.

While many agreed with the decision to lower interest rates, not all are convinced that inflation will continue lower. “I would say the worst outcome is stagflation — recession, higher inflation … I wouldn’t take it off the table,” JPMorgan Chase CEO Jamie Dimon said at a recent conference.

The Fed still has a difficult task

The Fed is trying to stick a soft landing, which has historically proven very difficult because the very thing needed to bring down inflation (higher interest rates) typically ends in deterioration of the labor market and a recession.

That’s why I initially thought the Fed would only do a quarter-point hike — because they haven’t won the war with inflation yet. The Fed is full of much brighter folks than me, and they’ve done a good job so far with this difficult balancing act, but I do think investors should be aware of the risk that accompanies this half-point hike.

If inflation rises, there could be much fewer rate cuts than the market is currently expecting. However unlikely, if inflation were to reverse course and rise again, the Fed might even have to raise rates again. And I do not think the market would be too happy about that.