Wall Street Pushes Fed into a Tight Spot as Recession Fears Rise
ByTao Dong
September 18, 2024
The Federal Reserve faces a difficult decision this week as Wall Street intensifies its calls for a larger-than-expected interest rate cut, fueled by renewed recession concerns.The market’s desire for a 50-basis point reduction is putting pressure on the Fed to act decisively, even as inflation remains a concern.
Last week, the market witnessed a dramatic shift in sentiment. While a 50-basis point cut seemed unlikely after August’s CPI data showed a rebound in inflation, a Wall Street Journal report on Thursday indicated that some Fed members wereconsidering the option. This, coupled with former New York Fed President William Dudley’s statement in Singapore that there were strong reasons for a 50-basis point cut, triggered a market frenzy. Futures markets now price a 40% probability of such a move.
This predicament presents a dilemma for policymakers. Beyond stabilizing prices and maximizing employment, the Fed has also implicitly adopted maintaining financial market stability as a third policy objective. A smaller rate cut could lead to a stock market sell-off, as investors perceive the Fed as lagging behind thecurve. Conversely, a 50-basis point cut could trigger a bond market selloff, as investors speculate that the Fed might be aware of unknown economic risks.
The market’s recent focus on a large rate cut has not only created a difficult situation for the Fed but also potentially increased the risk of volatility inrisk assets. From the Fed’s perspective, while inflation appears to be under control, the economy and consumer spending remain resilient, and the housing market is recovering, the risk of a sudden slowdown in the labor market is increasing. Under these circumstances, adjusting interest rates to a level that no longer restricts economic growth is natural,but the key lies in the pace and magnitude of the adjustment.
In 2022, the Fed misjudged the inflation situation, viewing the price increases as transitory. The market has since become more willing to challenge the Fed’s assessments, arguing that the recession has already begun.The Fed, lacking confidence in its own judgment, has repeatedly emphasized that everything depends on the data. However, the Fed is also aware that it cannot afford another mistake, needing to navigate a delicate balance between avoiding excessive panic and seizing the opportunity to guide the economy toward a soft landing.
Therefore, the upcoming decisionis likely to be a difficult one, as the situation remains unclear. A hasty large rate cut could send the wrong signal to the market. However, based on recent market performance, a smaller cut might not be enough to appease Wall Street. A misjudgment this time could significantly damage the Fed’s credibility, given its consistent guidance for a 25-basis point reduction.
While both a 25-basis point and a 50-basis point cut are possible, a 25-basis point reduction seems more likely. My underlying logic and judgment remain unchanged: the US economy is still operating within anormal range. However, the Fed’s decision-making is increasingly influenced by Wall Street. Therefore, a 25-basis point cut accompanied by dovish statements from Fed Chair Jerome Powell and an emphasis on data dependency might be the most appropriate policy choice.
Harris’s Triumph in DebateShifts Market Sentiment
Beyond the Fed’s decision, another significant development last week was the televised debate between Democratic presidential candidate Kamala Harris and Republican candidate Donald Trump. This debate had the potential to shift the election landscape.
Harris, who had been criticized for her lack of media presence and perceived weakness in debates,delivered a confident and compelling performance, effectively countering Trump’s attacks. Trump, on the other hand, appeared unprepared and unfocused, resorting to personal attacks and unsubstantiated claims. This was one of Trump’s weakest performances, while Harris shone, demonstrating the composure and communication skills required of a US president.
This debate has led to a significant shift in market sentiment. The Trump trade, which had been prevalent in recent months, has stalled. The trajectory of US bonds and the dollar needs reassessment, as do the energy sector and corporate tax policies. While Harris’s economic policies are still emerging, analystsexpect her to largely follow the Biden administration’s approach. However, as she stated in the debate, she is not Biden. Analysts are now actively exploring Harris’s economic policies, fiscal philosophy, and industrial plans, anticipating the emergence of a Harris trade.
This week, the focus will be on theFed’s interest rate decision, with a 25-basis point cut expected, although a 50-basis point cut cannot be ruled out. The dot plot, which provides a summary of individual Fed members’ projections, may indicate a larger rate cut later this year. Powell’s comments duringthe press conference will be closely watched, and the market could experience significant volatility.
The Bank of Japan is expected to maintain its current policy stance but may hint at a rate hike in October. The Bank of England might pause its rate cuts but could signal a reduction in November, while also providing guidance on futurebalance sheet reduction. Additionally, Japan and the UK’s CPI data will be closely monitored.
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