Fed expected to cut interest rates despite rising inflation. Here’s why

(WASHINGTON) — A fresh inflation reading this week flashed a warning: Price increases are rising again, just when the Federal Reserve had appeared close to declaring “mission accomplished” in its yearslong fight to lower them.

In theory, the trend would prompt the Fed to raise rates, or at least hold them steady, when central bankers meet next week. High interest rates, after all, are the main tool the Fed has used to ratchet inflation down from its pandemic-era heights.

Instead, investors peg the chances of a rate cut next week at an overwhelming 98%, according to the CME FedWatch Tool, a measure of market sentiment.

The reason is clear, experts told ABC News: Interest rates will remain historically high even after a small cut. The Fed likely does not view a mild uptick of inflation this fall as enough to deviate from a path of rate cuts it laid out earlier this year, they added.

“I don’t think the recent inflation has diverged enough from what the Fed expected to change its outlook,” William English, a professor of finance at Yale University and a former Fed official, told ABC News.

Consumer prices rose 2.7% in November compared to a year ago, marking two consecutive months of rising inflation, government data this week showed.

Inflation has slowed dramatically from a peak of more than 9% in June 2022. But the recent uptick has reversed some progress made at the start of this year that had landed price increases right near the Fed’s target of 2%.

That progress had helped nudge the Fed toward its landmark shift to interest rate cuts.

In recent months, the Fed has cut its benchmark rate three-quarters of a percentage point, dialing back its fight against inflation and delivering some relief for borrowers saddled with high costs.

Even after the cuts, the benchmark rate stands between 4.5% and 4.75%, its highest level in nearly two decades. The high interest rates have kept borrowing costs high for everything from credit cards to mortgages.

The average interest rate for a 30-year fixed mortgage stands at nearly 6.7%, well above an average rate four years ago of 2.6%, Freddie Mac data shows.

A small rate cut by the Fed would not meaningfully reduce mortgage payments for new loans, Yeva Nersisyan, a professor of economics at Franklin & Marshall College, told ABC News. In turn, the rate decision poses little risk of boosting demand for big-ticket items, like homes, which make up prices most immediately sensitive to lower rates. Other prices operate on a prolonged lag in response to changes in interest rates, she added.

“In that sense, a quarter of a percentage point cut or not really wouldn’t make a difference for inflation,” Nersisyan said.

The anticipated rate cut also reflects the Fed’s consideration of employment, which makes up the other component of its dual mandate besides inflation, English said. The unemployment rate has increased this year from 3.7% to 4.2%, though it remains at a historically low level. Hiring has slowed down but remained solid.

Lower interest rates are meant to stimulate economic activity over the long term, keep the economy growing and safeguard the labor market.

“They’ve been trying to balance two risks: One is that the economy slows more than they thought, and the other is that inflation proves more stubborn than they thought,” English said.

Still, experts cautioned that the recent uptick in inflation may delay or alter plans for rate cuts next year.

“Starting next year, they probably will take a more cautious outlook,” Nersisyan said.

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