Fed to cut rates by 25 bps despite market bets for 50 bps, says Barclays By Investing.com

Investing.com — Barclays strategists believe they will cut interest rates by 25 basis points (bps) on Wednesday, despite market prices strongly favoring a 50 basis point cut.

Even after a stronger-than-expected retail sales report on Tuesday, market expectations for the September Fed meeting remained unchanged, with a 65-70% chance of a 50bp rate cut now priced in.

This marks a sharp increase from just a few weeks ago, when the probability of a 50bp cut was around 17%. Interestingly, this rise in market shares occurred even as the last two major data came in above consensus.

According to Barclays, there are good reasons for the Fed to consider a 50bp cut. Minutes from the July FOMC meeting showed that several members supported a 25bp cut at the time. Since then, the economy has seen two relatively weak employment reports and a weak inflation reading.

“The Fed clearly believes policy is tight and does not want the labor market to slow further,” strategists explained in a note.

“He doesn’t seem worried about another wave of rising inflation after the past few months of good reports. The argument might be: “Let’s get to 4-4.25% quickly and then see how the economy goes; we might as well start with a 50bp cut,’” they added.

On the other hand, several economic indicators suggest caution about a further rate cut.

The unemployment rate remains low at 4.2%, core PCE inflation is still above 2.5% and consumption has been stronger than expected. Moreover, the economy is targeting growth of over 2% in Q3.

Strategists note that the Fed typically avoids 50bp cuts unless there is a financial crisis or significant job losses. Financial conditions eased, with lower mortgage rates, higher inventories and a weaker dollar.

A 50 basis point cut could also complicate future policy by raising expectations for more aggressive cuts and could require the Fed to revise its unemployment rate forecasts to justify such a move.

“If the Fed cuts 50bps, how does that stop investors from expecting 50bps cuts at subsequent meetings? And if this is the policy path, will the Fed suddenly raise its unemployment rate forecast to justify it?” asked the Barclays team.

“If the Fed cuts 50bps at this meeting, it will validate market prices,” they added. However, it would mean that markets have moved from a very low probability of a 50bp cut to a 65-70% chance, despite near-term data suggesting against such a move, likely caused by more by external noise than by economic fundamentals.

“The central bank usually tends to go with market prices. We think this is one of the few times a data-dependent Fed should reject them. We still think the Fed cuts by 25 bps in September,” the strategists concluded.