Higher-than-expected consumer price data – and some wholesale prices – over the past two days have led markets to price in a greater likelihood that the Federal Reserve will opt for a smaller, more conservative rate cut at its September meeting.
A bigger drop could send stock prices lower.
According to the CME FedWatch Tool, investors on Thursday put the chance that the Fed will cut rates by 50 basis points at next week's meeting at just 15%. A week earlier, the chance was 44%.
Some strategists have said a 25 basis point rate cut would be a better signal from the Federal Reserve.
Eric Wallerstein, chief market strategist at Yardeni Research, reasoned that the Fed would likely not cut rates by more than 25 basis points “unless there is a recession or a financial crisis.”
Read more: What the Fed's rate decision means for bank accounts, CDs, loans and credit cards
“For anyone who’s calling for a 50 basis point rate cut, I think they really need to reconsider how much volatility that would create in short-term funding markets,” Wallerstein told Yahoo Finance. “It’s just not something the Fed wants to risk.”
To make Wallerstein’s point, while the most recent jobs report showed continued signs of a slowdown in the labor market, economists largely reasoned that it did not show the substantial slowdown that many believed would be necessary to prompt the Fed to make a deeper cut. The risk is that a significant deterioration in the labor market signals a recession.
Meanwhile, Wednesday's Consumer Price Index (CPI) report showed that based on core prices, which exclude the more volatile costs of food and gas, prices rose 0.3% in August from the previous month, above Wall Street's expectation of a 0.2% increase.
“The unwelcome news on inflation will distract somewhat from the Fed's renewed focus on the labor market and make it more likely that authorities will stick to a more dovish approach to easing, starting with a 25-year period [basis point] “Interest rates are set to be cut next week,” Michael Pearce, deputy chief U.S. economist at Oxford Economics, wrote in a note to clients on Wednesday.
Some on Wall Street have also pointed out that a 50 basis point rate cut could send a more ominous signal about the health of the U.S. economy than the central bank would like to convey.
“A 50 basis point rate cut would cause panic. It almost feels like we’re completely behind the curve at this point,” Jennifer Lee, senior economist at BMO Capital Markets, told Yahoo Finance.
DataTrek co-founder Nicholas Colas analyzed every Federal Reserve rate cut cycle since 1990. Of the five cut cycles in that period, the Fed started with a 50 basis point cut each time (in 2001 and 2007), only to quickly enter a recession.
“While the data here is sparse, there is something to be said for associating an initial 25 basis point cut with a midcycle policy correction and 50 basis points as a signal that the Fed is too far behind to avoid a recession,” Colas wrote in a note to clients Wednesday morning. “Chairman Powell and the rest of the FOMC certainly know this history. Their first cut will almost certainly be 25 basis points.”
As of Wednesday morning, markets were expecting 100 basis points of cuts from the Federal Reserve this year. More clues about the Fed’s thinking will come on Sept. 18, when the Federal Reserve releases its Summary of Economic Projections, including its “dot plot,” which charts policymakers’ expectations about where interest rates might be headed in the future.
Wallerstein reasoned that it wouldn't necessarily be bad for stock prices if the total amount of Fed rate cuts this year falls short of market expectations.
“If those rate cuts are not factored in because growth is stronger than expected and GDP is strong in the third quarter and labor market indicators are not that bad, and we continue to see consumer spending, [increasing]“Then stocks have more room to rise as earnings continue to rise,” Wallerstein said.
Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.
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