Market Analysis

According to Barclays, the Fed will lower rates by 25 basis points despite market expectations of a 50 basis point drop

Amos Simanungkalit · 18 Sep 202425K Views

Barclays strategists predict that the Federal Reserve will lower interest rates by 25 basis points (bps) on Wednesday, even though market sentiment strongly favors a 50 bps reduction.

Despite a better-than-expected retail sales report on Tuesday, market expectations for the Fed's September meeting have remained steady, with a 65-70% probability of a 50 bps cut now being factored in. This marks a significant increase compared to a few weeks ago when the likelihood of such a cut was only around 17%. Interestingly, this shift has occurred despite the last two key data releases exceeding market forecasts.

Barclays highlights that there are valid reasons for the Fed to consider a more substantial 50 bps cut. July's Federal Open Market Committee (FOMC) minutes revealed that several members supported a 25 bps reduction at that time. Since then, the economy has seen two underwhelming employment reports alongside a weaker inflation reading.

“The Fed believes its policy is restrictive and wants to avoid further softening in the labor market,” Barclays strategists said in a note.

They also noted, “The Fed does not seem concerned about a resurgence in inflation after several months of stable reports. The case might be, 'Let’s get to 4-4.25% quickly and assess the economy afterward, starting with a 50 bps cut.'”

However, several economic indicators suggest caution in making such a large cut. The unemployment rate remains low at 4.2%, core PCE inflation is still above 2.5%, and consumer spending has been stronger than anticipated. Additionally, third-quarter economic growth is tracking above 2%.

Barclays strategists also point out that the Fed generally avoids making 50 bps cuts unless there is a financial crisis or severe job losses. Financial conditions have also loosened, with lower mortgage rates, higher stock prices, and a weaker dollar.

A 50 bps cut could complicate future decisions, potentially raising expectations for more aggressive cuts down the line. This might force the Fed to adjust its unemployment rate forecast to justify such a move.

“If the Fed cuts 50 bps, how will it prevent investors from expecting another 50 bps cut at future meetings? And if that becomes the case, will the Fed need to significantly revise its unemployment forecast?” Barclays strategists questioned.

They also noted, “A 50 bps cut would validate market expectations, but it would mean that markets have shifted from assigning a very low probability to a 65-70% chance of such a cut, despite recent data not fully supporting this shift. The market seems to be driven more by external factors than by the economic fundamentals.”

“The Fed generally aligns with market pricing, but we believe this is one of the rare instances where a data-dependent Fed should push back. We still expect a 25 bps cut in September,” Barclays concluded.