Federal Reserve’s Decision to Cut Interest Rates: What a 50bp Cut Could Mean for the Economy

With anticipation mounting, the U.S. Federal Reserve is poised to make a pivotal decision on interest rates, possibly marking the first rate cut in four years. This move comes at a critical juncture as economic indicators and financial markets continue to send mixed signals about the direction of growth, inflation, and employment. Traders are increasingly betting on a more aggressive stance from the Fed, with expectations for a 50 basis point (bp) rate cut growing significantly in recent days. But what would such a bold move mean for the economy and the financial markets?

Market Speculation on a 50bp Rate Cut

Initially, the market priced in only a slim chance of a 50bp cut. However, this sentiment has shifted dramatically. A series of well-researched reports from major financial outlets such as the Financial Times and Wall Street Journal, alongside commentary from Fed insiders, have fueled the belief that the central bank may opt for a larger cut than previously expected. By Monday, swaps markets reflected a 65% chance of a 50bp cut, up from just 15% a few days prior. Notably, a piece by Wall Street Journal writer Greg Ip helped drive this sudden market shift. 

This growing confidence in a larger cut is also reflected in statements from key analysts. Nomura’s head of U.S. Treasury sales, Jack Hammond, noted that several Federal Open Market Committee (FOMC) members were already leaning toward rate cuts in July. The rationale behind these potential cuts is based on a few key points:

Unemployment Rate: The unemployment rate currently stands at 4.2%, higher than at the Fed’s last meeting when it was at 4.1%. This may indicate weakening in the labor market.

Inflation Projections: Core PCE inflation levels are lower than projections made in the Fed’s June summary.

Powell’s Stance on Employment: Fed Chair Jerome Powell recently emphasized that the Fed does not “welcome further labor market cooling,” indicating that employment might be the Fed’s primary focus in its upcoming decisions.

Despite this, there is division among experts. JPMorgan predicts a more consistent cutting cycle, forecasting 50bp cuts at both the September and November meetings, followed by smaller 25bp cuts in subsequent meetings. Their caution is based on historical data, which shows that previous rate-cutting cycles began with negative market performance.

Historical Context of 50bp Rate Cuts

Looking back, aggressive rate cuts have typically signaled deep economic concerns. Half-point cuts in January 2001 (post-dotcom bubble), September 2007 (pre-Great Financial Crisis), and March 2020 (pandemic-driven) all coincided with severe market distress. However, the circumstances surrounding those cuts were quite different from today’s macroeconomic environment.

Analysts like Charlie McElligott argue that the current cycle is unprecedented, describing it as a “steroidal, Frankenstein cycle.” In McElligott’s view, the Fed’s aggressive policy shifts in recent years—11 rate hikes within 18 months, with several 75bp increases—make a corresponding policy reversal more understandable. Thus, a 50bp cut today should not be viewed as alarming but rather as part of the Fed’s larger adjustment process to stabilize the economy.

Market Impact of Previous 50bp Cuts

Nomura’s analysis of past 50bp cuts shows that in the 30 days leading up to such cuts, the S&P 500 typically dropped 1%, with staples outperforming and tech stocks underperforming. Small-cap stocks, measured by the Russell 2000, also historically slipped 1.7% during this period. 

Interestingly, three months after a 50bp cut, small-cap stocks have historically outperformed, with an average return of 5.6%. Value stocks also tend to outperform growth stocks, while the dollar strengthens, and the yield curve steepens.

Yet, as analysts caution, past performance is not always indicative of future results. The unique economic conditions of today—such as a relatively tight labor market, expanding profit margins, and household wealth increases despite the pandemic—make predicting the outcome of a 50bp cut more challenging.

Lessons from the 1995 Rate Cut Cycle

For many experts, the most appropriate historical analogy to today’s situation may be the Fed’s rate-cutting cycle that began in 1995. Back then, inflation was low, and unemployment was at 5.7%, similar to today’s conditions. The Fed initiated a modest 25bp cut to stimulate growth, which ultimately led to a soft landing and a rally in U.S. equities.

As TS Lombard’s Dario Perkins notes, the 1995 cutting cycle serves as a “template” for Powell’s current strategy. The key difference between then and now is the Fed’s view of its current policy stance. In 1995, rates were thought to be about 75bp above neutral, but today’s FOMC believes rates are at least 200bp above the neutral rate. This would suggest the need for quicker and deeper cuts to avoid stalling the economy.

Final Verdict: What’s at Stake?

The question remains: will a 50bp cut help or hurt? On one hand, a larger cut could signal to the market that the Fed is serious about addressing risks to the labor market and economic growth. It could also reassure investors that the Fed will act aggressively to prevent a deeper downturn.

On the other hand, a half-point cut risks sending a message of panic, potentially triggering a risk-off environment where investors flee from risky assets. This could particularly affect sectors like tech and energy, which have underperformed in past rate-cutting cycles.

While history provides some guideposts, the unique conditions of today’s economy mean that we are, as JPMorgan analysts put it, “navigating uncharted waters.” The Fed’s decision will set the tone for the months ahead, and whatever happens, markets will be watching closely.