Will High Core Inflation Force the Fed to Settle for a 25-Basis Point Cut?

Expectations for a 50-Basis Point Cut Surge, But Core Inflation May Block It

As of Friday, market expectations for a 50-basis point rate cut from the Federal Reserve surged sharply. Comments from former New York Fed President Bill Dudley, along with reports from the Financial Times and Wall Street Journal, boosted the odds of a larger rate reduction. However, core inflation data released earlier in the week raises serious doubts about whether the Fed can afford such an aggressive move.

Significant Jump in 50-Basis Point Cut Expectations

Friday saw a notable shift in market sentiment toward a 50-basis point cut, with traders increasing the probability of such a move to nearly 50%, according to the CME FedWatch Tool. Just a day earlier, the likelihood of this larger cut had been pegged at only 28%. As of Friday afternoon, traders placed a 49% chance on the Fed delivering a 50-basis point reduction at its meeting on Wednesday.

The optimism was fueled by comments from Dudley, who argued there was a strong case for a bigger cut to support economic growth. This, coupled with reports suggesting that Fed policymakers were seriously considering the option, pushed traders to reassess the likelihood of a more aggressive move.

Core Inflation Says “No” to a Larger Cut

However, Wednesday’s core inflation data complicates the picture. The Consumer Price Index (CPI) report for August showed core inflation – which excludes food and energy prices – rising more than expected. This higher-than-anticipated inflation figure remains well above the Fed’s 2% target, making a 50-basis point cut appear risky.

Seema Shah, chief global strategist at Principal Asset Management, noted, “Core inflation is still too high for the Fed to confidently execute a 50-basis point cut. Doing so could reignite inflation pressures, which the Fed cannot afford at this point.”

Is the Market Wrong About the 50-Basis Point Cut?

The real question is whether the market is overestimating the chances of a 50-basis point cut. Before the inflation report, most traders were expecting a 25-basis point reduction, which remains the safer bet given the inflationary pressures. But after Dudley’s comments and media reports, expectations for a larger cut jumped significantly, even as inflation data signals the need for caution.

The 25-basis point cut is now seen as a near-certainty, but the 50-basis point cut is up in the air. Despite the market’s growing belief that a larger cut could be on the table, the underlying economic data suggests otherwise.

Outlook: 50-Basis Point Cut Unlikely

In conclusion, while market sentiment has shifted toward a potential 50-basis point cut, core inflation remains a significant obstacle. It’s more likely that the Fed will opt for a 25-basis point cut, as this strikes a balance between supporting the economy and containing inflation. Traders should be prepared for volatility as the Fed’s decision on Wednesday will likely hinge on this delicate balance.