By Investing.com — Barclays strategists believe the Federal Reserve will cut interest rates by 25 basis points (bps) on Wednesday, despite market pricing heavily favoring a 50 bps reduction.
Even after a stronger-than-expected retail sales report on Tuesday, market expectations for the September Fed meeting remained unchanged, with a 65-70% chance of a 50bp rate cut now priced in.
This marks a sharp surge from just weeks ago when the probability of a 50bp cut was around 17%. Interestingly, this increase in market odds has occurred even though the last two major data releases have come in above consensus.
According to Barclays, there are valid reasons for the Fed to consider a 50bp reduction. The minutes from July’s FOMC meeting revealed that several members supported a 25bp cut at the time. Since then, the economy has seen two relatively weak employment reports and a soft inflation reading.
“The Fed clearly believes policy is restrictive and does not want the jobs market to slow any further,” strategists explained in a note.
“It does not seem worried about a new wave of rising inflation after the last few months of wellbehaved reports. The argument could well be, ‘Let’s just get to 4-4.25% quickly and then see how the economy is doing; we might as well start with a 50bp cut’,” they added.
On the other hand, several economic indicators suggest caution on a larger rate cut.
The jobless rate remains low at 4.2%, core PCE inflation is still above 2.5%, and consumption has been stronger than expected. Moreover, the economy is tracking over 2% growth in Q3.
Strategists note that the Fed typically avoids 50bp cuts unless there’s a financial crisis or significant job losses. Financial conditions have eased, with lower mortgage rates, higher stocks, and a weaker dollar.
A 50bp cut could also complicate future policy by raising expectations for more aggressive cuts and might require the Fed to revise its jobless rate forecast to justify such a move.
“If the Fed cuts 50bp, how does it prevent investors from expecting 50bp cuts at subsequent meetings? And if that is the policy path, will the Fed push up its jobless rate forecast sharply to justify it?” Barclays’s team asked.
“If the Fed cuts by 50bp at this meeting, it will validate market pricing,” they added. However, it would mean that the markets moved from a very low probability of a 50bp cut to a 65-70% chance despite near-term data suggesting against such a move, arguably driven more by outside noise than by economic fundamentals.
“The central bank usually tends to go with what the market is pricing. This, we think, is one of the few times that a data-dependent Fed is supposed to push back. We still think the Fed cuts 25bp in September,” strategists concluded.
