As we approach September 18th, all eyes are on the Federal Reserve and its next move regarding interest rates. The market remains uncertain about whether the Fed will implement a 25 or 50 basis point (bps) rate cut, with current pricing indicating a mix of both possibilities. As investors and traders await clarity, understanding the rationale behind these potential cuts and their broader implications is crucial for navigating the current economic landscape.
As of: 09/07/24
The Uncertainty Around the September Rate Decision
At the time of publishing, the rates market is pricing 32.5 bps for the next cut, which reflects uncertainty about whether the Federal Open Market Committee (FOMC) will opt for a 25 or 50 bps reduction. This ambiguity suggests the market is on the fence, with no clear indication of which direction the Fed will take. On one hand, a 25 bps cut seems more plausible given that there is no immediate economic emergency or significant inflationary pressure. On the other hand, a 50 bps cut might be necessary to address missed opportunities from earlier in the year and to ensure the Fed stays ahead of potential economic weakness.
Arguments for a 25 Basis Point Cut
Proponents of a more conservative 25 bps cut argue that this approach aligns with the Fed’s current stance of taking incremental steps unless there is a clear emergency. Fed Chair Jerome Powell’s past statements suggest that larger cuts or hikes are reserved for situations of economic instability or a de-anchoring of inflation expectations, neither of which seem to apply at the moment. Inflation has not reignited, and the labor market, while showing signs of cooling, is not in crisis mode. Some indicators, such as the job openings-to-unemployed ratio and the Kansas Fed labor market indicator, have returned to levels seen in 2017-2018, suggesting a healthy economy that is gradually normalizing rather than collapsing.
A 25 bps cut would serve as a form of insurance, signaling to the market that the Fed is willing to act if necessary but does not see the need for aggressive action. This approach would allow the Fed to maintain flexibility and continue monitoring economic data before making more significant moves in future meetings.
The Case for a 50 Basis Point Cut
On the other side of the debate, there are compelling arguments for a more aggressive 50 bps cut. One of the key reasons for this larger cut is the timing of the next FOMC meetings. With no meeting scheduled for October and the next one slated for November, some argue that waiting too long to take action could leave the Fed behind the curve. Additionally, it’s possible that the Fed already wanted to cut rates by 25 bps in July but held off, meaning a 50 bps cut now would be a way of catching up on missed opportunities.
Another factor supporting a larger cut is the need for the Fed to manage its communication carefully. A 50 bps cut might signal to the market that the Fed is not panicking but is simply adjusting to the reality of economic data, especially as the labor market shows signs of softening. Powell has made it clear that the Fed does not welcome further cooling in the labor market, and several labor market indicators suggest that the Fed may need to act more decisively to prevent further weakening.
The Role of Communication and Market Expectations
The Fed’s communication strategy will play a crucial role in shaping market reactions to the rate cut decision. The Fed often places key speakers strategically after major announcements, such as nonfarm payroll reports, to manage expectations. As we saw last Friday, senior Fed officials, Christopher Waller and John Williams, spoke shortly after August US jobs data to clarify the Fed’s rationale and reassure the market that the cut is not a sign of panic but rather a calculated move to stay ahead of potential risks.
If the Fed opts for a 50 bps cut, it could influence market psychology by establishing a new baseline for future cuts. Investors might then expect larger cuts in the event of a recession or other economic shocks. On the other hand, a 25 bps cut would signal a more cautious approach, allowing the Fed to make smaller adjustments as needed while keeping its options open for future meetings.
The Long-Term Outlook: Terminal Rates and the Pace of Cuts
While much of the current focus is on whether the September cut will be 25 or 50 bps, the broader question is how fast the Fed will move toward its terminal rate. The terminal rate represents the level at which the Fed will stop cutting rates and maintain stability. Currently, the market is pricing in a terminal rate of around 2.9%, which is higher than pre-pandemic estimates but reflects the economic realities of higher deficits and evolving market conditions.
The speed at which the Fed reaches this terminal rate will depend on several factors, including the strength of the labor market, inflation trends, and global economic conditions. If the Fed begins with a 50 bps cut, it may set the stage for faster rate cuts in the future, especially if a recession looms on the horizon. Conversely, a more gradual approach with 25 bps cuts would allow the Fed to assess the impact of each move before proceeding further.
Global Considerations: The Impact of China and Commodities
In addition to domestic economic factors, the Fed’s decisions are also influenced by global developments. China’s economic slowdown, driven by a centrally planned deleveraging of its real estate sector, has had ripple effects on global commodity demand. This slowdown has led to weaker demand for key commodities like oil, copper, and iron ore, which in turn affects economies that rely heavily on exports to China, such as Australia and New Zealand.
The decline in commodity prices and the weakening of the Chinese economy add another layer of complexity to the Fed’s decision-making process. While the U.S. economy remains relatively strong, global headwinds could impact growth prospects, making it even more important for the Fed to strike the right balance between cutting rates to support the domestic economy and avoiding excessive cuts that could fuel inflation or asset bubbles.
Conclusion
As the September 18th Fed meeting approaches, the market remains divided on whether the next rate cut will be 25 or 50 bps. Both options have valid arguments, with a 25 bps cut signaling caution and a 50 bps cut reflecting a desire to catch up on missed opportunities and stay ahead of potential risks. Ultimately, the Fed’s communication strategy and the broader economic context, both domestically and globally, will shape the outcome and the market’s reaction.
Regardless of the size of the September cut, the focus will soon shift to how quickly the Fed moves toward its terminal rate and whether global factors, such as China’s economic slowdown, will influence future decisions. For now, the market is left to speculate, with each data point adding to the puzzle of understanding the Fed’s next move.
3 Responses
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Thankyou