Following the Jackson Hole annual banking conference, FOMC chair Jay Powell has already stated what the market anticipated, that rate cuts are coming. How many cuts should we expect?
At Jackson Hole, Powell stated that the Federal Reserve would do “everything we can to support a strong labor market as we progress towards price stability”. Moreover, he acknowledged the focus of the Fed has shifted from taming inflation to supporting the weakening labor market: “the upside risks to inflation have diminished, and the downside risks to employment have increased”.
Currently, the market is pricing in at least one 25bp rate cut, even though the odds also show that a 50bp cut is not out of the question. The table below presents the Fed’s rate cut probabilities based on the bond market.
Table: Target rate probabilities for 2024-2025
Source of data: CME
As you can see, the bond market is placing a 32% chance of a 50 bp rate cut in the upcoming September meeting. However, the Fed has always been a conservative bunch, so I doubt, at this point, they would go for a 50bp cut; the two main ways the Fed may consider such a move is if the stock market plunges by over 10% in the coming weeks, which, for now, does not seem likely; following the last FOMC meeting, the stocks started to fall, indicating market participants did not like the Fed’s decision not to start cutting rates back in late July; however, for now, the initial market tantrum seems to have subsided. Moreover, the decline in long-term rates since the July meeting will likely relieve the financial markets until the September meeting and provide some more relief even without the Fed cutting rates.
Another way is if the following economic data, most notably, CPI, jobs report, and retail sales, all point to further decline in inflation and growing weakness in consumer spending and the labor market.
The Sahm rule already suggests that the economy is in a recession, even though this time could be different due to immigration. Hence, if the following jobs report shows an additional uptick in unemployment, which is likely, it would signal that the U.S. economy is in a recession or heading into one. Such a scenario would make a better case for the FOMC to move faster and cut rates more aggressively.
Finally, the bond market expects between 1 and 2 rate cuts every meeting for the rest of the year, for a total one percentage point reduction by December. Again, I doubt the Fed would go this far if we do not see further weakness in the labor market or a stock tumble. So, for now, the more likely scenario is a 25 bp coming September. After that, the Fed may consider a live event at every meeting, but it would require either a market crash or more evidence of weakness in the labor market with no further upward surprises from inflation.