Big Rate Cut Forces Fed to Contend With New Obstacles

But chief among the questions the Fed can’t easily answer now that it is cutting: Where is the Fed taking rates and how fast will it get there?

The Fed doesn’t know on either front. Officials often set policy with an eye toward figuring out where their interest rate is relative to a so-called neutral rate that neither spurs nor slows growth. The neutral rate can’t be observed. Before the pandemic, most Fed officials thought this neutral rate had fallen to 2.5% or lower. Now, many think the rate has risen. Possible contributors include soaring government deficits and new sources of demand for investment.

Powell characterized the Fed’s latest cut, which lowered the benchmark federal-funds rate to between 4.75% and 5%, as “recalibrating policy down over time to a more neutral level.” While he has typically avoided offering specific pronouncements about where that might be, he volunteered on Wednesday that “the neutral rate is probably significantly higher than it was” before the pandemic.

“How high is it? I just don’t think we know,” Powell said.

How fast the Fed cuts is also a wild card, and Powell tried to dissuade investors of the view that a half-point cut should be the default path at the central bank’s next meeting in November. “There’s no sense that the committee feels it’s in a rush to do this,” he said. “I do not think that anyone should look at this and say, ‘Oh, this is the new pace.’”

Just as the decision over whether to initiate rate cuts with a traditional quarter-point reduction or a larger half-point reduction was unusually unpredictable in the run-up to this meeting, the Fed faces the prospect that continued mixed signals on the economy create similar uncertainty for their next meeting.

Officials will have two more months of labor-market data before the Nov. 6-7 meeting, including one report less than a week before their meeting.

With inflation cooling, Wednesday’s decision represented a valiant effort to manage against the risks of an undesirable slowdown in hiring, said Loretta Mester, who retired as president of the Cleveland Fed in June. But the uneven communications around the move in the run-up to the meeting might occur again.

“Going into the next meeting, it’s going to be, again, ‘25 or 50? What’s the case for not doing 50 again?’ And so that just makes it a little more complicated,” she said.

To be sure, Powell tried to put guardrails around expectations of additional rate cuts of 0.5 point, or 50 basis points, by pointing to officials’ rate projections released Wednesday. “It’s not completely convincing because the” last set of quarterly projections, in June, “never signaled this 50-basis-point cut,” said Dean Maki, chief economist at the hedge fund Point72 Asset Management.

Fed officials are trying to balance two risks: One is that they drag their heels on reducing rates in a way that gives rise to rising joblessness and makes officials rush into bigger cuts.

“It is a race between the labor-market deceleration that’s happening and the Fed reducing restrictiveness” before the weakness leads to a downturn, said Priya Misra, portfolio manager at J.P. Morgan Asset Management. “If this is the start of a weakening in the labor market, they should have more urgency” to keep making bigger cuts.

The other risk is that they move too fast in dialing back rate hikes. The chances that inflation gets stuck at a level above the Fed’s 2% target “increase if the Fed does continue to do 50-basis-point cuts going forward” when the economy doesn’t need them, said Maki.

Even if tactical questions remain, Powell answered bigger questions about the Fed’s strategy, said Mester, by following up his speech in Jackson Hole, Wyo., last month with specific action on Wednesday. Those earlier remarks made clear that further labor-market weakness wouldn’t be welcomed.

“His Jackson Hole speech was pretty explicit. Usually, chairs aren’t as explicit as he was there,” said Mester. “I know everyone is focused on 25 or 50, but the big message is, ‘Look, the committee has become much more confident that inflation is going back down to 2% over time, and they’re attuned to the labor-market risks.”

Powell tried to strike a balance on Wednesday between signaling concern about the economy and complacency about those risks to employment. “It bears watching, and we’re watching,” he said. “There is thinking that the time to support the labor market is when it’s strong, and not when you begin to see the layoffs.”

Over the last two weeks, more former Fed officials had urged the Fed to start with a larger cut to better balance the risks facing the economy even though public comments from some of Powell’s colleagues had implied they were more comfortable leading off with a smaller cut. Powell has prioritized consensus building, reflected in a string of 17 meetings with no dissenting votes that came to an end on Wednesday.

 “I didn’t know whether he would be able to get the committee on board, and he did,” said Misra. “So it also tells you the power he has over the committee.”

Write to Nick Timiraos at Nick.Timiraos@wsj.com