The Fed lowers the key interest rate and still faces a test of strength

And it is moving. On Wednesday, the US Federal Reserve (Fed) lowered its key interest rate for the first time this year. It has long ignored the threats of US President Donald Trump, who wants much lower interest rates. Now, however, the Fed has determined that, given the risks to the labor market, an easing of monetary policy is warranted.

As expected, the US Federal Reserve limited its interest rate to a 0.25 percentage point cut, to between 4 and 4.25 percent. Monetary policy in the dollar zone thus remains slightly restrictive – according to experts, the neutral interest rate would currently be somewhere between 3 and 3.5 percent. Interest rates in the euro zone and Switzerland are significantly lower.

The stock market initially reacted positively to the easing, but reversed course when Fed Chairman Jerome Powell characterized the rate cut at the press conference as "risk management." This statement suggests that the Fed does not yet view the labor market situation as dramatically deteriorating and that further interest rate cuts are not certain.

The US benchmark S&P 500 index fell slightly for a time. Yields on US government bonds initially fell before rising significantly again. This means that the bonds themselves have lost value. The dollar has gained ground against other currencies. This is also a sign that the market is pricing in fewer interest rate cuts in the US following Powell's press conference.

For the second time in a row, the twelve voting members of the Federal Open Market Committee (FOMC) were unable to agree on a unified position: Stephen Miran, until recently Trump's economic advisor, voted for a large rate cut of 0.5 percentage points. Governors Christopher Waller and Michelle Bowman, who are considered possible successors to Jerome Powell and who deviated from the majority opinion in July, voted in line with the Fed chairman himself this time. This despite having an incentive to curb appeal to the White House by calling for significant easing.

Nevertheless, this time the interest rate decision was accompanied by great unrest: Only on Monday evening, a few hours before the FOMC began its meeting, did it become clear which Fed governors would be able to participate and vote.

On the one hand, the Senate confirmed the nomination of Stephen Miran, who, in his previous role as Trump's economic advisor, sharply criticized the Fed and Jerome Powell. Miran, meanwhile, has only put his job in the White House on hold and not completely resigned. Many observers see this as a risk to the Fed's independence. At the press conference on Wednesday evening, Powell offered only a brief response to this issue: The board remains committed to the goal of maintaining its independence.

On the other hand, a court also ruled Monday evening that Governor Lisa Cook may continue to attend Fed meetings, even though Trump wants to fire her without notice. Trump allies accuse Cook of making false statements when taking out two mortgages.

The Fed governor vehemently defends herself against this accusation. Just this weekend, the news agency Reuters reported that the mortgage bank had indeed received the correct information from Cook, which would not constitute deception.

The new economic forecasts from the nineteen participants at the FOMC meeting demonstrate how difficult it currently is to predict the future development of the American economy. In June, a narrow majority expected the key interest rate to be between 3.75 and 4 percent by the end of the year – seven of the nineteen participants even anticipated no further cuts and a key interest rate level of between 4.25 and 4.5 percent.

Today, a different picture emerges, but the panel remains divided. While six participants believe the Fed will keep the key interest rate at its current level until the end of 2025, nine members expect the key interest rate to be between 3.5 and 3.75 percent in December.

One person deviates completely from the consensus and even expects a key interest rate of only 2.75 to 3.0 percent by the end of the year. The Fed does not disclose which participant made which forecast. However, it is reasonable to assume that the only newcomer, Miran, expressed his strong preference for low key interest rates.

The bottom line is that the Fed will cut interest rates again at each of its final two meetings of the year. Financial markets, spooked by weak job growth figures, had already been hoping for such a significant easing. According to derivatives market data from the CME Group, shortly before the FOMC meeting, more than two-thirds of market participants expected further rate cuts in October and December. This prospect of further interest rate cuts was also the reason why the US stock market has performed so strongly recently.

However, the central bank finds itself in a difficult position. On the one hand, the labor market has cooled, as new data has shown in recent weeks. While the unemployment rate remains low at 4.3 percent, this is primarily due to declining immigration.

Companies are creating few new jobs but have so far refrained from mass layoffs. Some economists, however, fear that it will take little for that to happen. Poorer Americans have already noticeably curtailed their consumption due to the uncertainty. Only wealthy consumers, who are benefiting from the bull market on the stock market and high real estate prices, are keeping the economy going with their spending.

Taken in isolation, this initial situation argues for a moderate interest rate level. However, the Fed must consider that inflation, at 2.9 percent, is still too high. And further trouble looms on the price front. The Trump administration's high tariffs are only having an impact with a significant delay – many retailers waited to raise prices until they had cleared their inventories of duty-free products and gained a better understanding of Trump's bilateral agreements.

However, many economists expect companies to now make up for such price increases. Inflation could well rise again to 4 percent by the end of the year. How companies and employees will react to this, and whether inflation will subside soon, is difficult to predict.

Beyond next year, long-term inflation expectations remain well anchored, Powell emphasized early in the press conference. The Fed's baseline scenario assumes that Trump's tariffs will only result in a one-time spike in inflation. However, the risk of a sustained rise in inflation must be monitored, Powell warned.

It's unusual for inflation to remain elevated while the labor market is weakening. Powell said Wednesday evening that he was not at all surprised that views within the FOMC (on the future direction of the key interest rate) diverged in this initial situation.