The latest inflation data released Wednesday has prompted a significant shift in market expectations regarding the Federal Reserve’s upcoming rate decision. With a hotter-than-expected Consumer Price Index (CPI) report, traders are now anticipating a more cautious approach from the Fed at its September meeting, with a higher likelihood of a smaller interest rate cut. A deeper cut could potentially unsettle equities markets, triggering a sharp sell-off.
As of mid-week, the probability of a 50-basis-point rate cut by the Federal Reserve has plunged to just 13%, down from 44% just a week ago, according to the CME FedWatch Tool. This shift reflects growing sentiment that the central bank may opt for a more measured approach, with many strategists advocating for a modest 25 basis point cut instead.
Strategists Advocate for a Conservative Cut
Eric Wallerstein, chief markets strategist at Yardeni Research, is among those who believe the Fed is unlikely to cut rates by more than 25 basis points unless faced with severe economic stress. “Absent recessionary conditions or a financial crisis, a larger cut seems off the table,” Wallerstein noted. His caution underscores a broader reluctance on Wall Street to endorse aggressive monetary easing, given the potential for increased volatility in short-term funding markets.
The potential risks of a 50-basis-point cut were further highlighted by the latest jobs data, which showed only modest slowing in the labor market. This outcome falls short of the significant cooling many investors believed would be necessary to justify a more aggressive move by the Fed. While there are signs of easing, a sharper deterioration in labor conditions could signal recession risks.
Inflation Surprises Add to Uncertainty
Complicating the picture for the Fed is the CPI report, which revealed that core inflation—excluding volatile food and energy prices—rose by 0.3% in August, exceeding Wall Street’s expectation of a 0.2% increase. This inflation uptick is likely to reinforce the Fed’s cautious stance. As Michael Pearce, deputy chief US economist at Oxford Economics, pointed out, “The unwelcome news on inflation will distract slightly from the Fed’s renewed focus on the labor market and makes it more likely that officials stick with a more measured approach to easing, beginning with a 25 basis point cut next week.”
Some analysts warn that a 50 basis point cut could send a troubling signal about the Fed’s confidence in the economy’s health. “A cut of that magnitude would suggest panic,” said Jennifer Lee, senior economist at BMO Capital Markets. “It would imply the Fed feels it is behind the curve, which isn’t the message they want to send right now.”
Historical Patterns Suggest Caution
History appears to be on the side of caution. Nicholas Colas, co-founder of DataTrek, analyzed every Federal Reserve rate-cutting cycle since 1990 and found that in both instances where the Fed began its cycle with a 50 basis point cut (in 2001 and 2007), a recession followed shortly thereafter. “While the data here is sparse, there is something to be said for associating an initial cut of 25 basis points with a mid-cycle policy correction,” Colas observed. “Chair Powell and the rest of the FOMC certainly know this history. Their first cut will almost certainly be 25 basis points.”
Market Implications and Forward Guidance
As of Wednesday morning, markets are pricing in a total of 100 basis points of cuts from the Fed this year. However, much depends on the forthcoming Summary of Economic Projections, set to be released on September 18, which will provide further insights into the Fed’s thinking, particularly through its “dot plot” chart, which maps out individual policymakers’ expectations for future rate paths.
Should the total rate cuts this year fall short of market expectations, it might not necessarily spell bad news for stocks. Wallerstein argues that fewer cuts could be positive if they reflect stronger-than-expected growth metrics. “If growth is robust, GDP is strong in Q3, and labor market indicators hold up while consumer spending continues to grow, then stocks will have more room to run as earnings continue to grow,” he explained.
Key Takeaways
- Market Shift: A hotter-than-expected inflation report has prompted markets to price in a higher likelihood of a smaller, 25 basis point rate cut by the Fed, rather than a 50 basis point cut.
- Strategist Opinions: Many on Wall Street advocate for a conservative approach, arguing that a larger cut could signal panic and introduce unwanted volatility.
- Historical Context: Past rate-cutting cycles suggest that an initial 50 basis point cut is often followed by a recession, lending weight to arguments for a more measured policy.
- Forward Guidance: The Fed’s upcoming Summary of Economic Projections will be crucial for understanding its rate path, with the potential for market adjustments if cuts fall short of expectations.
Conclusion
For investors, the Fed’s September meeting represents a pivotal moment in shaping near-term market sentiment. A cautious approach, with a smaller rate cut, might offer a more stable path forward for equities. Traders should closely watch the Fed’s guidance on September 18 to gauge the future trajectory of rates and adjust strategies accordingly.
