After Wednesday's higher-than-expected inflation data, markets quickly adjusted their rate expectations to make a smaller, more conservative rate cut more likely at the Fed's September meeting. A bigger rate cut would likely send stocks sharply lower.

As of Wednesday, investors were pricing in a 13% chance of a 50 basis point rate cut at the Fed’s meeting next week, down from 44% a week ago, according to the CME’s FedWatch tool.

Some strategists said a quarter-point rate cut would be a more welcome signal from the Fed.

Eric Wallerstein, chief market strategist at Yardeni Research, believes the Fed is unlikely to cut rates by more than 25 basis points "unless recession conditions or a financial crisis emerge."

“For all the people calling for a 50 basis point rate cut, I think they should seriously consider the volatility that this is going to create in short-term funding markets,” Wallerstein said. “That is not a risk the Fed wants to take.”

As Wallerstein noted, while the most recent jobs report showed signs of a continued slowdown in the labor market, economists generally agreed that it did not show the substantial cooling many believe would be needed to push the Federal Reserve to cut interest rates more aggressively. The risk is whether a sharp deterioration in the job market is signaling a recession.

Meanwhile, Wednesday's Consumer Price Index (CPI) report showed that the core CPI, which excludes more volatile food and gasoline prices, rose 0.3% month-on-month in August, higher than Wall Street's expectations of 0.2%.

“Negative news on inflation will slightly distract the Fed from the labor market and make officials more likely to stick with a more cautious approach to easing, starting with a 25 basis point rate cut next week,” Michael Pearce, deputy chief U.S. economist at Oxford Economics, wrote in a note to clients Wednesday.

Some on Wall Street also noted that a 50 basis point rate cut could say a more ominous message about the health of the U.S. economy than the Fed would like to convey.

“A 50 basis point rate cut is going to feel like a panic attack, like we’re completely behind the curve now,” said Jennifer Lee, senior economist at BMO Capital Markets.

DataTrek co-founder Nicholas Colas analyzed every Fed rate-cutting cycle since 1990. Of the five rate-cutting cycles during that period, only twice did the Fed start its rate-cutting cycle with a 50 basis point cut (in 2001 and 2007), and both were followed by recessions.

“While the data here is sparse, it does tie a first 25bp cut to a mid-cycle policy adjustment, while a first 50bp cut would likely mean the Fed is behind the curve and cannot avoid a recession,” Colas wrote in a note to clients Wednesday. “Powell and the rest of the FOMC are certainly aware of this history. Their first cut will almost certainly be 25bp.”

As of Wednesday, markets were pricing in a 100 basis point rate cut this year. More of the Fed’s thinking will come after its Sept. 18 meeting, when the central bank is expected to release a summary of its economic projections, including its “dot plot,” which depicts policymakers’ expectations for where interest rates might go in the future.

Wallerstein believes that if the Fed cuts interest rates less than the market expects this year, it will not necessarily be a bad thing for the stock market. He said:

“If these rate cuts are off the table because growth is stronger than expected, GDP is strong in the third quarter, labor market indicators are not too bad, and we continue to see consumer spending increase. Then there is more room for stocks to run higher as earnings continue to grow.”

Article forwarded from: Jinshi Data