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

The Federal Reserve’s 

decision to lower interest rates by half a percentage point,

announced on Sept 18, 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 dissented from the decision. Ms 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 per cent odds that the Fed would cut rates by a quarter-point and 35 per cent odds of a half-point. By the day before the decision, pricing had flipped, indicating a 65 per cent 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.