Why Wall Street Probably Doesn’t Want a Big Interest Rate Cut Next Week

Wall Street is finally confident it knows what the Federal Reserve will do at its policy meeting next week, and a bigger-than-expected interest rate cut may not be a welcome surprise.

A debate has been raging in markets for weeks: Will the U.S. central bank cut its benchmark federal funds rate by a modest 25 basis points (bps) at its September 18 meeting or slash it by 50bps?

The debate appeared to be settled Wednesday when data suggested the Fed’s fight against decades-high inflation isn’t over yet. Core inflation, which excludes volatile food and energy prices, rose 0.3% in August, slightly above expectations. While most of that increase came from rising housing costs, the data suggested to some that aggressive rate cuts, once an attractive prospect on Wall Street, could risk reigniting inflation.

By the end of the day, market expectations for a 50bps cut had fallen to below 15%, according to CME Group’s FedWatch tool, which uses federal funds futures trading data to forecast interest rates. By Thursday, those odds had rebounded to 28% but remained well below where they were just weeks ago.

That, wrote Deutsche Bank analyst Jim Reid in a note Thursday, could tie the Fed’s hands at its next meeting. 

“Given the shift in market pricing, it’s making it increasingly hard for the Fed to cut by 50bps without triggering a significant market surprise,” Reid wrote. In the current policy cycle, the Fed, Reid pointed out, has consistently delivered the rate move that markets expected, which would make a large cut next week all the more shocking and unsettling. 

The Reasons for a Rate Cut Matter

Just one month ago, markets were evenly split on whether the Fed would cut by 25 or 50bps in September. After a monthly jobs report from the government showed a surprise jump in the unemployment rate in July, some market participants worried that the Fed had waited too long to lower interest rates and advocated for aggressive cuts.

While lower interest rates are almost always a good thing for equities, the reason behind rate cuts matters to Wall Street too, says Quincy Krosby, Chief Global Strategist at LPL Financial. And even after July’s dismal jobs report, markets may not have known what to make of a 50bps cut.

“Does the market really want the Fed to cut rates because they’re worried about the labor market?” she said. “I mean, the market’s going to accept that, because what the market doesn’t want is the Fed to … see deterioration in the labor market and do nothing about it. But it also then suggests that the economy is slowing at a faster pace.” 

Fed officials, when asked whether they could hold an emergency meeting to cut rates, assured investors that they would act if the labor market continued to show signs of distress. Data in recent weeks has shown the labor market continuing to cool, though it hasn’t born out investors’ worst fears.

What Could Prompt a 50-Point Cut?

Markets are still expecting the Fed to cut rates by a full percentage point before the end of the year, implying at least one 50bps cut in one of the three remaining scheduled policy committee meetings.

That large of a cut, however, is exceedingly rare outside of economic crises. The last two times the Fed cut rates by more than 25bps, the bank was responding to the Covid-19 pandemic in March 2020 and the 2008 Global Financial Crisis. The Fed hasn’t cut rates by 50bps outside of a full-blown economic crisis since November 2002.

So what would compel the Fed to jump straight to jumbo rate cuts? It would likely take a “significant deterioration” in the labor market to prompt such a move. Although it’s not clear what individual FOMC members would consider a significant deterioration or whether a cut that big would require unanimity among committee members.

Deutsche Bank analysts in a note on Thursday estimated conditions that could trigger a jumbo cut include “payroll gains clearly slowing below 100k, a sharper rise in the unemployment rate, or any evidence that layoffs are picking up.”