The Federal Reserve's first easing of monetary policy after the worst inflation since the 1970s should have been seen as a welcome relief for the economy, but economists said the widely anticipated move this week was overshadowed by confused expectations and market volatility.

“This should be a moment of celebration, and to some extent it is,” Derek Holt, vice president of economics at Scotiabank, said in a note to clients. “Unfortunately, the Fed’s communication with the market has been quite poor, leading to heightened market volatility around expectations regarding the size and pace of rate cuts.”

Last week, the odds of a 50 basis point rate cut at the Fed’s September meeting surged from less than 20% midweek to nearly 50% late in the week, initially due to media reports citing former Fed officials as saying they supported a larger rate cut.

“The Fed is doing everything in its power to put a 50 basis point rate cut back on the table,” said Lou Crandall, chief economist at Wrightson ICAP.

Mark Chandler, chief market strategist at Bannockburn Global Forex, noted that such evenly matched bets are rare ahead of a Fed meeting.

“The market has been actively preparing for dovish messaging from Fed Chairman Jerome Powell and the FOMC this week,” said Scott Anderson, chief U.S. economist at BMO Capital Markets. “In my view, this increases the risk of a hawkish surprise that could at least temporarily roil the market.”

Many Wall Street economists are sticking with their calls for a modest 25 basis point rate cut at this week's meeting, but virtually all of them say it now looks like a close call. Some investment banks have expanded their expectations for a rate cut to 50 basis points. Some say Tuesday's weak August retail sales report could push the Fed toward a 50 basis point rate cut.

Why is there so much confusion in the market?

The challenge for economists is that the Fed’s response to the economy has become harder to predict, said Ethan Harris, former head of global economic research at Bank of America Securities.

Harris said most economists believed the Fed wanted to move gradually, but in its most recent rate hike cycle, the Fed abandoned that approach. Instead, it did not raise rates at the first sign of inflation, but then raised rates aggressively.

Before the coronavirus pandemic, gradualism was a big part of the Fed’s playbook. That’s because the outlook is always uncertain and the Fed has tried to avoid being erratic, Harris told MarketWatch by email.

Why doesn't the Fed make its intentions clear?

Scotiabank’s Holt said Fed officials may not know what to do and want to meet to discuss the issue. “That’s normal,” he said.

"On the other hand, there could be so many divisions among policymakers that there is no clear endorsement reflecting a unified stance. Or, it could be that the Fed does not see the need to intervene in a market sell-off," Holt added.

The case for a 50 basis point rate cut

Lou Crandall, chief economist at Wrightson ICAP, said the long-standing concern about the Fed's 50 basis point rate cut was that it could backfire and fuel concerns about the Fed's impending economic troubles. But last week investors seemed to see it as a more market-friendly Fed.

He added that recent surveys showed businesses were impatient for rate cuts.

Brian Bethune, an economist professor at Boston College, said U.S. manufacturers are starting to feel "beaten" by the strength of the dollar.

The case for a 25 basis point rate cut

Holt said there was no urgent need to expand rate cuts. Financial markets were functioning well and the U.S. economy was resilient.

He said the Fed may be more likely to manage the market with smaller rate cuts. "A 50 basis point cut now could give the market a gotcha moment and see it as a precedent. They may price in a big move in the future, which could prompt the Fed to adjust rates faster than it would like."

Antonio Gabriel, chief global economist at Bank of America Securities, said he would stick with his view for a 25 basis point rate cut. “The main message from the meeting should be one of cautious optimism despite downside risks,” he said.

Article forwarded from: Jinshi Data