The market is pricing in another 200 basis points of rate cuts through the end of 2025. Is it too much?

The Federal Reserve recently cut the target range for its federal funds rate by 50 basis points to a range of 4.75% to 5%, much to the delight of the market, which is now trading at or near historic highs. The market’s enthusiasm is tied to estimates that this is just the beginning of the Fed’s rate-cutting campaign, and that it could extend through the rest of this year and into 2025.

right CME GroupHis FedWatch tool, which looks at 30-day forward prices for the federal funds rate to track the likelihood of changes, slightly more than a quarter of traders (as of Sept. 25) expect to see the federal funds rate fall in a range of 2.75% to 3% until the Fed meeting in December 2025. This implies another 200 basis points of potential interest rate cuts over the next year and three months or so.

Is the market getting ahead of itself? Let’s take a look.

Balancing inflation and the labor market

Heading into the September Fed meeting, the market was torn between whether the Fed would cut by 0.25% or 0.5%. It all came down to whether the Fed would continue to focus on inflation, which was reported at 2.5% in August and remained above the Fed’s 2% target, or on the labor market, with unemployment rising and recently triggering the Sahm Rule , which proved. to be a reliable indicator of past recessions.

With the half point cut, it is clear that the Fed is encouraged by the slowdown in inflation and is now more focused on increasing unemployment to avoid a recession and get a soft landing for the economy. Fed Chairman Jerome Powell has made it clear that the Fed does not want to see any further deterioration in the labor market.

Fed officials have also been speaking to the public since their last meeting, and so far the market seems to believe their comments indicate another jumbo rate cut could be coming. Chicago Fed President Austan Goolsbee said in a recent response: “Over the next 12 months, we have a long way to go to get the interest rate to something like neutral to try to keep conditions where they are.” As of Sept. 25, the FedWatch tool showed 64 percent of traders expect another half-point cut at the November Fed meeting.

Image source: Getty Images.

Where things start to get murky is how the Fed balances its dual mandate. Inflation is not yet at 2%, and Powell, in his press conference following the September Fed meeting, said the Fed is not declaring victory over inflation and would like inflation to be around 2% for something time.

But the economy seems to be doing well, according to several parameters. August retail sales came in much better than expected. Conformable S&P Global Market Intelligence’s US Purchasing Manufacturing Index (PMI), a measure of business activity that tracks the manufacturing and service sectors, came in at 54.4 in September, slightly below August and ahead of expectations. A reading above 50 suggests expansion. However, the flash manufacturing PMI fell to a 15-month low of 47, coming in below expectations.

Of course, there is conflicting data, but where things could get dangerous for the Fed and the market is if inflation stays at current levels or even rebounds higher and falls short of the Fed’s 2% target. This makes deeper interest rate cuts harder to justify, although where unemployment goes from here is also very important.

Does the market reduce inflation?

The Fed’s decision to cut 50 basis points came with a dissent from a voting member of the Federal Open Market Committee, which has not happened in a rate decision since 2005. Fed Governor Michelle Bowman recently said he prefers a quarter point. cut, because it sees “higher risks to price stability, especially while the labor market continues to be close to full employment estimates.”

Much will depend on upcoming data, such as the closely watched monthly jobs report and the Consumer Price Index. If inflation remains sticky, the Fed may not be able to cut as much as the market currently believes, which could trigger a selloff in stocks.

I can’t predict the future, but I think investors should be aware of the complexities involved in these decisions and the difficulty the Fed may have in fulfilling its dual mandate.