The Market Wants a Bigger Cut
Someone call in the vice principal for student discipline! The market is bullying the Federal Reserve again.
Earlier this week, the economic data doused market expectations that the Fed might cut interest rates by 50 basis points. The consumer price index (CPI) came in around where expected, with core prices coming in a little bit hotter. The producer price index was similar: headline hit the consensus expectation, and core came in hotter.
Jobless claims barely budged, inching up 2,000 to 230,000. Weirdly enough, that is just the four week moving average of claims of 230,750, which was just about where the average was the week before. Jobless claims, in short, are once again in a holding pattern at a level that suggests that demand for labor is sufficiently strong to keep layoffs at bay.
By yesterday, the fed funds futures implied odds of a 50-basis point cut had fallen from around even with the odds of a 25-basis point cut to something like a one-in-four chance. This still struck us as far too bullish on cuts given the fact that the Fed meeting is less than a week away. At this point, the overwhelming consensus ought to be that the Fed will cut by one-quarter of a point when the meeting concludes on Wednesday.
The market thinks differently. As of the close of the equities market on Friday, the market was again pricing in even odds that the Fed would announce a 50-basis point cut next week. Keep in mind that there was almost no data that emerged on Friday to support this change of view. The only big news we got was the University of Michigan survey of consumers showing that inflation expectations fell to 2.7 percent. While that will be welcome news to the Fed’s expectation-watchers, it hardly warrants a half-point cut.
A Circle of Joy
It wasn’t just the futures market that seemed convinced a bigger cut is looming. Stocks rallied and bond yields fell. Watching the markets move on Friday, you got the sense that there was a sort of circular confirmation occurring. Futures looked to bonds and saw confirmation of a larger cut, triggering rising stocks, which encouraged bonds to rally and send a signal to futures, which encouraged stocks to rise further.
One reason for doubt about the larger cut is that it would send lots of confusing signals to markets. Many would likely see it as suggesting that the Fed is very worried that the economy is on a weaker footing than it appears to be. At the same time, the supporters of Kamala Harris would no doubt tout the larger cut as a sign that the threat of inflation was in the past—which would in turn provoke political backlash from the supporters of Donald Trump.
A 25-basis point cut would allow the Fed to send a message of cautious optimism about growth and inflation. The Fed has been suggesting that it is now more worried about downside risks to growth and employment than upside risks to inflation, but it is still worried about declaring the inflation threat over too early. We think the Fed is likely to want to proceed cautiously as it cuts, allowing the labor market to determine the pace so long as inflation continues to moderate.
So, what is the argument for a larger cut? According to some well-known monetary policy “rules,” the current federal funds rate is perhaps two points too high. So, a larger cut would move the Fed further along toward the level recommended by, say, the Taylor Rule.
The trouble with this is that there’s no reason for the Fed to rush toward a rules-based level. With the labor market showing signs of steadiness and inflation only creeping down slowly, a series of 25-basis points cuts will get the Fed there. Arriving at, say, a three percent fed funds rate a month or two early is not going to make much of a difference—so why not take things slow and steady?
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