The US Federal Reserve (Fed) has reduced interest rates by 0.5 percentage points in its first cut in over four years, leaving its federal funds rate at between 4.75 per cent and 5 per cent.

Marking its first step in an expected easing cycle, the size of the move has been described as a “surprise” to many investors, who may have anticipated a slower approach from the US central bank.

Easing begins

“The Fed has fired the starting gun with a supersized 0.5 percentage point cut to interest rates,” commented Quilter Investors investment strategist, Lindsay James.

“Investors had only begun to attribute a meaningful probability to a half point cut in the past week.

“Disappointing labour market data was published on the eve of the Fed’s blackout period, leaving it potentially unable to use forward guidance to its usual extent. This meant the meeting held an unusually high level of uncertainty for investors.

“However, with inflation falling further in subsequent data, officials will have weighed the risks of reigniting inflation against the evident cooling of the jobs market and clearly felt the scales tipped in favour of a larger cut.”

Further cuts

The announcement came alongside an update to the Fed’s dot plot, which shows where voting members of the Fed expect rates to be at the end of the next few calendar years.

A shift in expectations has been observed, with at least one further cut, if not two, anticipated before the end of this year.

“However, though the Fed has made a bold move in kicking things off with a 0.5 percentage point cut, it is perhaps more likely that we would see a 0.25 percentage point cut at its November monetary policy meeting as the Fed will still be reluctant to move too much too soon,” James added.

“Markets appear to have been a bit overzealous when it comes to pricing in how hard and fast the Fed will go with rate cuts, with rates expected to have fallen to around 3 per cent in a year’s time. The latest dot plot has shifted significantly lower for 2025, but it is still above the level implied by market pricing.”

St. James’s Place head of economic research, Hetal Mehta, echoed these sentiments, noting that the Fed had surprised most economics but placated markets by cutting by 0.5 percentage points.

“They say risks are balanced but this will be seen as dovish,” Mehta continued. “The aggressive rate cuts markets are pricing – over 200bps in less than a year – seem unwarranted to us.

“Something that risks getting lost in the 50bps excitement is that the longer run rate has been nudged up once again.”

Fidelity International global head of macro & strategic asset allocation, Salman Ahmed, added that the cut appeared to be “pre-emptive”, with both the dot plot and press conference comments signalling more caution when it comes to the pace and magnitude of easing policy going forward.

“All in all, it’s a somewhat hawkish 50 basis point cut,” Ahmed stated. “One thing is certain though, doves rule the FOMC and any further weakness to the labour market would bring more and faster cuts and now the markets know that.

“We maintain our view that soft landing remains the most likely outcome for this year.”

Immediate impact

Forvis Mazars chief economist, George Lagarias, outlined several things that will likely happen over the next few days following the rate cut.

“For one, expectations on future cuts will probably build up from this point forward, pushing bond yields further down and causing more steepening in the yield curve,” he said.

“If the Fed started aggressively there’s no reason why it should not continue in the same direction, the thinking will likely go.

“Second, investors will have to consider whether the US economy and thus earnings are more stressed than what they appear to be. A central bank cutting aggressively could, even inadvertently, emit a distress signal to markets.

“Third, the move could become an issue in the presidential campaign, further fuelling a discussion as to future of the central bank’s independence.

“Fourth, it will send a signal to the Bank of England and the European Central Bank that they should feel free to also cut aggressively, as they try to deal with weak growth conditions."

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