Wall Street Can’t Make Up Its Mind About How Big the Fed’s Rate Cut Will Be

Market participants raised their bets on Friday that the Federal Reserve will dive headfirst into rate cuts at its policy meeting next week. 

Traders put the odds that the Federal Open Markets Committee will cut its benchmark federal funds rate by 50 basis points next Wednesday at 47%, according to CME’s FedWatch tool, which uses fed futures trading data to forecast interest rate decisions. Markets saw a slightly higher chance (53%) of a smaller 25-basis-point cut. 

The chances of a cut of 50 basis points, or half a percentage point, were up significantly from earlier in the week when inflation data surprised to the upside, providing markets with a fresh reminder that prices are still rising faster than the Fed would like. That data seemed to confirm for Wall Street that, despite the risks of a cooling labor market, officials would approach rate cuts cautiously to avoid undoing the progress they’ve made in taming decades-high inflation. 

Stocks traded higher and bond yields dipped on Friday even as shifting rate expectations indicated markets are increasingly uncertainty about what the Fed will do at what is expected to be the most consequential policy meeting in more than a year.

Former NY Fed Head Sees ‘Strong Case’ For Big Cut

The odds calculated by CME can swing wildly, often changing throughout the day as economic data and other variables are factored into traders’ models.

Friday’s rise in expectations for a jumbo cut could stem from comments from former New York Fed President Bill Dudley, who said at a forum in Singapore on Friday that he saw “a strong case” for a 50-basis-point cut. 

Dudley argued that the rising risks to the labor market outweighed any lingering upside inflation risks. The pace of job gains has slowed dramatically in recent months—89,000 in July and 142,000 in August, compared with a monthly average of more than 200,000 in the first half of the year—raising concerns that the labor market has weakened more than expected and could rapidly deteriorate further. 

Economists have pointed out that job gains like those seen in August are hardly consistent with a recession, during which the economy usually loses jobs. Some experts have also noted that the slowdown has not coincided with a surge in layoffs, suggesting a growing labor force, not profound economic weakness, lies behind an ominous jump in the unemployment rate.

Still, economic data clearly illustrates the job market is cooling off, leading some to wonder whether the Fed has waited too long to start easing policy. 

Does Wall Street Want a Big Cut?

The Fed has, over the last few years, tended to act as the market expected. During the 2022-2023 tightening cycle, even though market expectations sometimes shifted in the week before the rate decision, the Fed’s move was always what markets thought was the most likely outcome.

With markets almost evenly split on whether it’ll be a 25-basis-point or 50-basis-point cut next week, the door is wide open for that pattern to be broken, giving Wall Street substantial leeway in interpreting the Fed’s action.

Over the last 20 years, most 50-basis-point cuts have come amid or immediately before a full-blown economic crisis. A big cut at next week’s meeting could signal panic on the part of policymakers and send markets reeling.

However, Wall Street, like Dudley, clearly sees a case for a large cut next week, in part because interest rates are so high—at least by 21st-century standards.

Dudley on Friday argued that the federal funds rate is currently as much as 200 basis points above the neutral rate, at which policy is neither accommodative nor restrictive. “So the question is,” he said, “‘Why don’t you just get started?'”

Wall Street could agree and see a big rate cut next week as simply the appropriate first step in the normalization of interest rates after an incredibly abnormal few years.