What a Larger-than-Expected Fed Rate Cut Could Mean for the Stock Market
Following a hotter-than-expected inflation report on Wednesday, markets have rapidly adjusted their expectations, now predicting a higher chance that the Federal Reserve will opt for a more conservative rate cut in September. A larger reduction could potentially cause significant turmoil in the stock market.
As of Wednesday, the likelihood of a 50 basis point rate cut next week is estimated at just 13%, down from 44% the previous week, according to the CME FedWatch Tool.
Strategists are suggesting that a 25 basis point cut might be a more prudent move from the Federal Reserve. Yardeni Research’s chief market strategist, Eric Wallerstein, argued that a cut exceeding 25 basis points would likely occur only in the event of recessionary conditions or a financial crisis.
Wallerstein cautioned against a 50 basis point cut, noting that it could introduce considerable volatility into short-term funding markets. “The Fed is unlikely to risk that,” he told Yahoo Finance.
The latest jobs report showed a continued slowdown in the labor market but not the significant cooling that would warrant a deeper cut. This leaves concerns that any further deterioration could signal a recession.
Additionally, the Consumer Price Index (CPI) report revealed that core prices, excluding food and gas, rose by 0.3% in August, surpassing Wall Street’s forecast of a 0.2% increase.
Oxford Economics deputy chief U.S. economist Michael Pearce noted that the inflation news might lead the Fed to maintain a more cautious approach, possibly starting with a 25 basis point cut next week.
Wall Street analysts have also suggested that a 50 basis point cut could be perceived as a sign of economic distress. “A 50 basis point cut might suggest panic and imply that we’re significantly behind the curve,” BMO Capital Markets senior economist Jennifer Lee told Yahoo Finance.
DataTrek co-founder Nicholas Colas reviewed past Fed rate-cutting cycles and observed that in previous instances where the Fed initiated a cycle with a 50 basis point cut (in 2001 and 2007), a recession followed soon after. “Given this history, an initial cut of 25 basis points is likely, as it represents a midcycle adjustment rather than a reaction to economic crisis,” Colas wrote in a note to clients.
As of Wednesday morning, markets are anticipating a total of 100 basis points of cuts from the Federal Reserve this year. More information will be available on September 18 when the Fed releases its Summary of Economic Projections and “dot plot,” which will outline policymakers’ future interest rate expectations.
Wallerstein suggested that if the Fed’s rate cuts fall short of market expectations but economic growth remains strong, this could actually be beneficial for stocks. “If growth exceeds expectations and GDP is robust, along with favorable labor market indicators and continued consumer spending, stocks could benefit from sustained earnings growth,” Wallerstein said.
