The Federal Reserve is expected to cut interest rates. How low will it go?

The Federal Reserve is widely expected to initiate an interest rate cut, likely 25 basis points, at its September meeting, primarily driven by a significantly weakening labor market despite inflation remaining above its 2% target. Market participants are pricing in a high probability of this reduction, with many economists anticipating further cuts by year-end, signaling the Fed's shift to prioritizing employment stability. However, the decision's unanimity and the extent of future easing remain subject to internal debate and political considerations, including the ongoing situation with Governor Lisa Cook.

Analysis

The Federal Reserve is on the cusp of a monetary policy pivot, with a rate cut at its September meeting now a high-probability event driven by a significant deterioration in the U.S. labor market. Recent data indicating a dramatic stall in hiring, including a meager 22,000 jobs added in August, an unemployment rate at its highest since October 2021, and substantial downward revisions to prior months' employment gains, are compelling the central bank to prioritize its maximum employment mandate. This shift occurs despite persistent inflation, with the August core CPI holding steady at 3.1%, well above the Fed's 2% target. However, the consensus among cited economists is that the weakening labor outlook now overshadows inflation concerns, a sentiment echoed by Fed Chair Powell who noted the rising downside risks to employment. While market pricing, per the CME FedWatch tool, indicates a 92% probability of a 25-basis-point cut, the decision is unlikely to be unanimous. Analysis from J.P. Morgan and Deutsche Bank suggests potential dissents from both hawkish members arguing for no change and dovish governors pushing for a more aggressive 50-basis-point reduction. This internal division, coupled with the unprecedented political and legal challenge concerning Governor Lisa Cook's tenure, introduces considerable uncertainty regarding the future pace of easing and the perceived independence of the institution.

Key Decisions for Investors

• Given the high probability of an initial 25 basis point cut, investors should position for the start of a broader easing cycle, which is historically favorable for rate-sensitive assets, but note that this first move is largely priced in.
• Investors must now prioritize monitoring labor market indicators, such as jobless claims and non-farm payrolls, as they have become the primary driver of Fed policy and will dictate the pace and depth of subsequent rate cuts.
• Pay close attention to the composition of dissents in the upcoming FOMC decision, as a deeply divided Fed could signal future policy uncertainty and heightened market volatility.
• While inflation is currently a secondary concern for the Fed, its persistence above 3% remains a key risk; any unexpected re-acceleration could constrain the Fed's ability to cut further and introduce stagflationary pressures.