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U.S. Federal Reserve – a close call

Market response

September 16, 2024 | 2 min read
Seema Shah
Chief Global Strategist
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The Federal Reserve (Fed) will begin its rate cutting cycle this Wednesday. Market expectations are split between a 25 basis point and a 50 basis point rate cut, as the decision is complicated by conflicting signals of solid economic activity but a weakening labor market. Rarely have market expectations been so torn, so close to a FOMC meeting.

Our own forecast has been for the Fed to cut policy rates three times this year—25 bps at each of its September, November and December meetings. However, we cannot rule out a 50 bps move this week and believe the decision will be highly debated within the Federal Open Market Committee.

Why 50 bps is potentially in play

There are three key reasons for the Fed to be actively considering a 50 basis points cut:

  1. Inflation: For the Fed, it comes down to deciding which is a more significant risk—reigniting inflation pressures if they cut by 50 bps, or threatening recession if they cut by just 25 bps. However, inflation numbers have improved meaningfully in recent months, with monthly core PCE inflation averaging just 0.1% for the past three months, down from 0.4% in 1Q 2024, and the annual rate now down to just 2.7%. With inflation seemingly contained, the Fed should be able to focus on the labor side of its dual mandate and frontload rate cuts to insure against recession.
  2. Credibility: Having already been criticized for responding to the inflation crisis too slowly, the Fed will likely be wary of being reactive, rather than proactive, to the risk of recession.
  3. Market reaction: Historically, a 50 bps Fed cut has prompted major market angst as investors question what the Fed knows about the depth of economic weakness that they don’t. However, market moves in the past three to four weeks, following the surprisingly weak July jobs report, suggest that the market may, in fact, react more negatively if the Fed only cuts by 25 bps versus 50 bps. On the days that market expectations have priced in a higher probability of a 50 bps cut, the broad market has risen, led by small-cap stocks and cyclicals. By contrast, on the days where a 25 bps move looks more likely, the opposite has happened. As a result, the Fed may have less to fear about a 50 bps cut than it typically does.

Yet, history is on the 25 bps side

While these are perhaps convincing reasons, historic Fed cutting cycles suggest a 50 bps cut would be unusual. Since the late 1980s, when Fed policy shifted away from large swings in policy rates and became more stable and credible, 25 bps cuts have become the norm, and 50 bps have been the exception.

There have only been two Fed rate cutting cycles that began with cuts greater than 25 bps in magnitude: January 2001 (bursting of the dot-com bubble) and September 2007 (sub-prime mortgage collapse). Both of those periods stood out from the rest, characterized by concerns around severe asset price bubbles and financial systemic risk.

While there are some vulnerabilities in the current cycle, global financial stability risks have receded. And while there have been concerns around a tech bubble, the fundamental productivity gains from AI, and strong earnings delivery from large tech firms, indicate that tech valuations are not as stretched as they were in the dot-com boom.

Looking beyond the 25 bps vs. 50 bps decision

Wednesday’s FOMC decision is a toss-up. Without an asset price bubble or systemic risk, a large cut is likely unnecessary. Yet, there is arguably nothing to lose by opting for a 50 bps cut, other than setting a precedent for future cutting cycles.

Ultimately, though, the 25 bps vs. 50 bps decision is less important than the fact that Wednesday will mark the beginning of the cutting cycle, with the Fed likely signaling that a string of rate cuts is in the pipeline. Although the U.S. labor market is clearly slowing, the continued strength of household and corporate balance sheets suggests that there is nothing so broken about the U.S. economy that a sequence of Fed cuts cannot fix. Risks around the FOMC forecast are elevated, but recession risk remains low.

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Views and opinions expressed are accurate as of the date of this communication and are subject to change without notice. This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The information in the article should not be construed as investment advice or a recommendation for the purchase or sale of any security. The general information it contains does not take account of any investor’s investment objectives, particular needs, or financial situation.

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