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Federal Reserve

The Fed has three options. Here's the difference between them, and why anything could happen

Key Points
  • The Federal Reserve meets next week and has three options on the table.
  • The central bank either can hold rates steady or cut by either a quarter point or half point. A rate hike is off the table.
  • Markets widely expect a quarter-point, or 25 basis points, reduction, through a more aggressive move is not impossible.

The Federal Reserve heads into its meeting next week with three choices, each carrying its own advantages as well as drawbacks.

Policymakers either can choose to hold interest rates steady, cut by a quarter or a half point. Raising rates isn't an option and may well not be for several years.

Markets are indicating that they have it figured out: The Federal Open Market Committee most likely will cut by a quarter point, with a small chance of a half-point reduction. There's virtually no chance given to holding steady, though two regional Fed presidents recently have said that's exactly what the committee should do.

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With the Fed currently pegging its overnight funds rate in a range between 2.25% and 2.5%, here's the difference between each move, particularly what a 50-basis-point cut would mean as opposed to a 25-point cut:

Quarter point: The most likely case

Judging by statements Fed officials have made in recent days, there's some support for implementing a more aggressive 50-point easing. But the 25-basis-point move seems more likely simply because the post-financial crisis Fed has been one to favor incrementalism rather than radical policy moves.

In short, the lower reduction will be an easier sell.

"Although you could certainly build the case for a stronger action, a 50 basis point cut, I just think it's going to be hard to get everyone on board with that," said Curt Long, chief economist at the National Association of Federally Insured Credit Unions. "Are we on the edge of a recession? If you are, then 50 basis points makes sense. But I don't think the majority of the Fed feels that way."

Indeed, the reduction could come down to what kind of message the Fed wants to send.

The lower option could simply be a way to undo the damage caused in December when the Fed approved a 25 basis point hike, despite a tumbling stock market and fears over tariffs and a global slowdown. A 50 basis point hike, on the other hand, could signal something more serious, like fears over a more fundamental slowdown in growth.

"The Fed made a policy mistake last year," said Quincy Krosby, chief market strategist at Prudential Financial. "It's hard to think that they will not come in at 25 basis points at the minimum, because [Chairman Jerome Powell] will have a lot of explaining to do if they don't."

Half point: One and done?

Adopting a 50 basis point, or half percentage point, cut would acknowledge something deeper — that not only was the December hike in error but that the Fed feels it needs to correct markets and guard against potentially greater damage to the economy.

Going for the half-point move offers a variety of benefits, said Joe LaVorgna, chief economist for the Americas at Natixis.

"It gives the Fed more optionality in the sense that the Fed might be able to wrestle market expectations back in more balanced way," he said. "One way to wrestle them back is to make it a bigger than expected move in July and then wait, actually be data dependent. You take out a little bit more insurance and kind of wrestle market expectations back. They can be less dovish, they can be more balanced if they move 50."

Markets aggressively priced in the more dramatic cut during a brief move Thursday sparked by a speech from New York Fed President John Williams. The influential official said in a speech that the Fed should act quickly and forcefully when it seems economic headwinds building, comments the market took to mean a 50 basis point cut was coming.

But a Fed spokesman quickly walked back the remarks, saying Williams was only speaking theoretically and not in a way that should be interpreted as policy intention.

"By going to cut more, hopefully you're done," LaVorgna said. "If the economy's OK and weathers the storm, you're done, vs. the more drip, drip, drop let's wait and see and do things on a meeting by meeting basis. Fifty gets you out in front."

He added that the move would help reverse a yield curve inversion that saw short-term yields, specifically in the fed funds rate, move higher than the 10-year Treasury note, in the past a classic recession signal.

Holding the line

Market-implied possibility of not changing rates is at zero and has been there for weeks. That doesn't mean there's no support on the FOMC for staying pat. Boston Fed President Eric Rosengren told CNBC on Friday that interest rates don't need to change, and Kansas City Fed President Esther George made similar comments recently to the Wall Street Journal.

In making the case for a cut, Fed officials have cited the U.S.-China tariff battle, slower global growth and low inflation, among other concerns.

But there's certainly nothing overt in the economic signals pointing to a need for more easing. The stock market is trading around record highs, second-quarter economic growth is likely to be around 2%, and the consumer looks to be on solid ground.

"Why is [a rate cut] compelling now when the incoming data has been pretty solid and trade talks with China are restarting? I think that's a good question," said Bill English, a 20-year Fed veteran and now a professor at the Yale School of Management. "Assuming they cut rates at this meeting, I think Jay [Powell] will have to explain what's changed from June that made them want to take this step."

English expects Powell to reiterate concerns about China, inflation and softer investment spending that could weigh on the economy ahead.

"Any of those three reasons may carry the day for various members of the committee," he said. "The communication around the policy decisions will be really important ... It's an interesting time and should be an interesting meeting. Almost more interesting will be the communication around the decision. That should help explain where the committee's coming from."