Why it matters whether the Federal Reserve delivers a small or large rate cut

The Federal Reserve is universally expected to begin cutting rates at its policy meeting next week. The only question is, by how much?

After a slightly hotter than expected inflation report on Wednesday, traders curbed their expectations for a 50 basis point rate cut. However, an article from the Wall Street Journal’s Nick Timiraos – widely considered the top Fedwatcher/whisperer in the media – that frames the 25-vs-50 discussion is reversing most of the prior day’s move, with the implied odds of a 50 basis point cut rising back to about 30%.

All this raises the question: does the size of the first rate cut really matter for anyone other than the short-term interest rate traders making levered bets on the outcome? 

Yes, in three key ways:

In your prime

Changes in monetary policy famously impact the economy with so-called “long and variable lags.” Telegraphed changes can also influence market conditions (and, to a much lesser extent, economic activity) before they even happen. For instance, the US 10-year Treasury yield is down about 140 basis points from its 2023 peak, which has put downward pressure on some key borrowing rates.

Some — but not all. The Fed’s policy rate is linked to the prime rate that determines interest payments on floating rate obligations like auto and small business loans. The size of the cut will directly impact how much those borrowers are spending on interest payments (and by extension, how much money they have to spend on everything else).

Great rate expectations

The market’s modal expectation, at present, is that the Federal Reserve will deliver 100 basis points worth of rate cuts by year end. It’s seen as about twice as likely that rates will be 125 basis points lower by year end than only 75 basis points below the current range of 5.25 to 5.5%.

At this meeting, monetary policymakers won’t just be making an interest rate decision — they’ll also be releasing an updated set of projections on the outlook for the economy and policy rates.

It would be a very odd state of affairs for central bankers to deliver a 25 basis point cut and project more than 75 basis points in easing for 2024 as a whole (with just two more meetings left to go). Investors, perplexed, would be saying, “Well, why aren’t you just cutting by more right now?”

The combination of market confidence in a 25 basis point cut to start and a larger reduction in rates within the months that follow will likely require incremental labor market softness in order to be validated. That information will take time to come. In the interim, traders would likely have to reckon with a Fed saying, if a 25 basis point cut is delivered, that it doesn’t plan on moving faster than that through year end.

That is, there would be the strong potential for Treasury yields to move higher, even as the Federal Reserve cuts interest rates, because of the signal they’d be sending on the outlook for rates and how that differs from current market expectations. Lowering rates without improving borrowing conditions would not be a great outcome for a central bank looking to make policy less restrictive.

Not so full house

And any reversal in the recent downward trend in yields would not be a positive for US real estate, which has, so far, not been very sensitive to the 160 basis point decline in mortgage rates since late October. 

And when I asked strategists and economists about the economic signals that would tell monetary policymakers they’ve cut rates enough, one common answer was “whenever the real estate market turns higher.”

A larger rate cut is going to give more cause for confidence that the stance of monetary policy will induce more housing activity as well as the use of homes as ATMs to protect consumption from drifting lower as the job market loses momentum.

“One argument is that there’s nothing wrong with the economy that rate cuts can’t fix,” said Neil Dutta, head of US economics at Renaissance Macro Research. “But the Fed needs to want to be the solution, and if we can’t say that definitively, that’s a problem.”