An ongoing rout in equity markets, fueled partly by fears that the Federal Reserve has kept interest rates too high for too long, will not force central bank officials to slash rates before their September meeting, Fed watchers said.
However, the Fed is now expected to cut rates significantly more before year-end than previously anticipated. It is unlikely to move earlier unless the stock market's woes spread quickly through the broader economy.
"A stock market drop, by itself, is not enough to justify a rate cut," said Patrick Horan, a macroeconomist with the Mercatus Center at George Mason University. "However, if the Fed believes the sell-off represents a financial tightening, which would adversely affect unemployment or bring inflation below the 2% inflation target, then a cut before September would be warranted."
Stocks have been in freefall since the Fed on July 31 chose to hold its benchmark interest rate at a roughly 20-year high, where it has been for over a year. Losses accelerated as the July jobs report showed that payroll growth slowed faster than expected and unemployment rose to its highest level since October 2021.
Deterioration risk
Numerous labor market indicators, including job openings, hiring and wage growth, are all deteriorating and are on course to weaken further as consumer and corporate borrowing remains constrained by restrictive monetary policy, said Julia Pollak, chief economist at ZipRecruiter.
"I do think there is a risk of labor market conditions deteriorating before rate cuts are approved, and possibly even for a few months after cuts begin, since it may take 100 basis points of cuts or more to make a meaningful difference," Pollak said.
On Aug. 5, the odds of the Fed cutting rates by 50 basis points by September were at about 84%, according to the CME FedWatch Tool, which measures investor sentiment in the fed funds futures mark. A month earlier, the odds of a cut that large were about 5%.
Before 2024-end, about 60% of the futures market now sees reductions totaling 125 basis points. The odds of cuts that substantial were near zero just a week ago.
While Fed officials may ultimately start their policy easing process with "supersized" cuts, stock declines will not be enough for interest rate changes before September, said Michael O'Rourke, chief market strategist with JonesTrading.
"For an emergency rate cut you would need some type of financial or credit crisis to be forming or a major geopolitical event, like the pandemic or a war," O'Rourke said.
One key issue for markets has been high valuations, and initial rate cuts will do little to address that, O'Rourke said. A 50-basis-point cut in September will bolster a slowing but not collapsing economy and prevent the Fed from "falling behind the curve," O'Rourke said.
"I believe the complaints about the Fed and policy are overstated," he said. "The data did not warrant a rate cut last week, and even if it did it would not have changed the course of events that have unfolded."
Other forces
While the sell-off could be pinned on fears of a US recession, much of it was sparked by circumstances largely outside the domestic economy, including the unwinding of the yen carry trade, where borrowing in yen to buy riskier assets was impacted by the Bank of Japan's decision to raise rates.
"If US stocks were selling off because of the US economy, a rate cut from the Fed would be the perfect remedy," said Bret Kenwell, a US investment and options analyst at eToro
While stock market investors may continue to hope for a rate cut sooner than September, Fed officials will remain unlikely to act even if equities fall further, said Arnim Holzer, global macro strategist at Easterly EAB Risk Solutions.
"We continue to believe that the Fed is also looking at holistic normalization, not simply getting rates right for the equity markets," Holzer said. "As a result, issues such as the long-term inflationary expectations, the structure of the labor force and unemployment, and preserving real return for savers are likely to play a role in their thinking. The implications of that are that equity markets may not get the short-term salve they want."