After a hotter-than-expected inflation reading on Wednesday, markets have quickly moved to price in a higher likelihood that the Federal Reserve will opt for a small interest rate cut at its September meeting.
Markets sold off following the read-through that the Fed won’t cut interest rates by 50 basis points as some had hoped. The S&P 500 (^GSPC) and Dow Jones Industrial (^DJI) both fell more than 1.5% within two hours of the report before paring some losses.
But some strategists have argued that a 25 basis point cut would be a more welcome sign from the Federal Reserve.
Yardeni Research chief markets strategist Eric Wallerstein reasoned the Fed likely wouldn’t cut by more than 25 basis points “absent recessionary conditions or a financial crisis emerging.”
“For everyone who’s asking for a 50 basis point cut, I think they should really reconsider, the amount of volatility that would cause in short-term funding markets,” Wallerstein told Yahoo Finance. “It’s just not something the Fed wants to risk.”
To Wallerstein’s point, while the most recent jobs report showed continued signs of slowing in the labor market, economists largely reasoned the August jobs report didn’t reveal the substantial cooling that many believed would be needed to prompt a deeper cut from the Fed. The same could be said for the August Consumer Price Index (CPI), which showed prices increased at the lowest annual rate since early 2021.
But details inside the report showed on a “core” basis, which strips out the more volatile costs of food and gas, prices in August climbed 0.3% over the prior month, above Wall Street’s expectations for a 0.2% increase.
“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,” Oxford Economics deputy chief US economist Michael Pearce wrote in a note to clients on Wednesday.
Further clues into what the Fed is expecting the interest rate cut cycle to look like will come on Sep. 18 when the Federal Reserve releases its Summary of Economic Projections, including its “dot plot,” which maps out policymakers’ expectations for where interest rates could be headed in the future.
As of Wednesday morning, markets are expecting 100 basis points of cuts from the Federal Reserve this year. Wallerstein reasoned that if the total amount of Fed cuts this year falls short of the market’s expectations that isn’t necessarily a bad thing for stocks, though.
“If those rate cuts get priced out because growth is stronger than expected and GDP comes in strong for the third quarter and the labor market indicators aren’t too bad, and we keep seeing consumer spending [increasing], then stocks will have more room to run as earnings continue to grow,” Wallerstein said.
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