Federal Reserve moves closer to cutting rates. The question will soon be: how fast?

WASHINGTON (AP) — Two years after launching an aggressive fight against inflation and one year after keeping its key interest rate at its highest level in nearly a quarter century, the Federal Reserve is expected to signal this week that it will cut borrowing costs likely as early as September.

A rate cut this fall — the first since the pandemic — would be a game-changer and a potential boost to the economy. The Fed’s rate cuts typically lower borrowing costs for things like mortgages, auto loans and credit cards.

A single cut in the Fed’s key rate, now around 5.3%, would not by itself make much difference to the economy. Financial markets generally expect this. Some borrowing costs have already fallen slightly in anticipation of the move. The key question for the central bank will therefore be: how quickly and how far will policymakers ultimately cut rates?

It’s an issue that’s also of great importance to both major presidential candidates. Any sign that the Fed will cut rates soon could boost the economy and potentially boost Vice President Kamala Harris’s chances of election. Former President Donald Trump has argued that the Fed should not cut rates until its next meeting, in November, two days after the election.

Futures markets have priced in a 64% probability that the Fed will cut rates three times this year, in September, November and December, according to CME FedWatch. As recently as last month, Fed officials collectively forecast just one rate cut in 2024 and four in 2025 and 2026, suggesting they are leaning toward a more moderate pace of rate cuts, about once a quarter.

How the economy performs in the coming months will likely determine how quickly the Fed acts. Should growth remain solid and employers continue to hire, the Fed may prefer to take its time and cut rates slowly as inflation continues to decline.

“They want to be very gradual in how they pull back,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. “But if the labor market actually looks like it’s slowing,” Goldberg suggested, Fed officials might conclude that “they should move a little bit faster than they otherwise would.”

There are signs that the labor market is cooling, as the Fed intended. Job growth has averaged a respectable but unspectacular 177,000 per month over the past three months, down from the red-hot quarterly average of 275,000 a year ago.

It is not yet clear whether the cooling signals a return of the economy to a more sustainable, less inflationary, post-pandemic period of growth, or whether the cooling will last until the economy enters a recession.

“That’s the big question right now,” Goldberg said.

Chairman Jerome Powell and other Fed officials have stressed that they are paying almost as much attention to the threat of a decline in employment as they are to inflationary pressures. That shift in the Fed’s emphasis on ensuring the labor market doesn’t weaken too much has likely fueled market expectations for a rate cut.

“Increased inflation is not the only risk we face,” Powell said in testimony before Congress earlier this month, after the most recent jobs report showed the unemployment rate rose for the third straight month to a still-low 4.1%. Still, Powell also characterized the labor market and growth at the time as “strong.”

The government said on Thursday that the economy grew at a healthy annual rate of 2.8% in the April-June quarter, although the figure followed weak growth of 1.4% in the first three months of the year.

“The economy looks pretty solid right now,” said William English, an economist at the Yale School of Management and a former senior Fed official. “I don’t think there are any real signs right now that anything bad is going to happen.”

English, like many observers, believes Powell will provide a clearer picture of future rate moves during his annual speech in August at the Fed’s monetary policy conference in Jackson Hole, Wyoming. This week, however, the Fed could change the statement it issues after each meeting in ways that could signal a rate cut is imminent.

In its statement after the June meeting, it said: “Modest further progress has been made toward the Fed’s 2% inflation target in recent months.” When it issues its new statement on Wednesday, the Fed could drop “modest” or otherwise modify it to emphasize that further progress has been made on inflation.

In June, Fed policymakers forecast that annual inflation would average 2.8% in the final three months of this year. On Friday, the government said inflation has already fallen below that level, to 2.5% in June, according to the Fed’s preferred measure.

If inflation remains below the Fed’s end-point target, that could justify a sharper cut in lending rates than the single cut policymakers predicted in June.

Still, even if price pressures ease, annual inflation may not fall much further this year — and could even rise a bit toward the end of 2024. That’s because monthly inflation rates fell to very low levels in the second half of last year. So even low monthly rates in the coming months may not bring annual inflation down.

Fed officials, however, are expected to focus much more on the three-month and six-month annualized inflation averages in the coming months. The three-month average of the Fed’s preferred inflation gauge, which excludes the volatile food and energy categories, fell to just 2.3% in June.