Thank you, sir, may I have another?

That’s the main takeaway for markets-based rate cut expectations following the Federal Reserve’s widely-expected ¼-point cut for its target rate announced on Wednesday. Although key Treasury yields popped yesterday (suggesting anxiety about rate cuts when inflation is edging higher and is well above the Fed’s 2% target), market signals still point to expectations that the Fed will continue to ease monetary policy. The driving factor for the Fed’s decision: a slowing labor market, which the central bank sees as the bigger risk at the moment vs. inflation.

Explaining the cut, the Fed’s FOMC statement advised: “Recent indicators suggest that growth of economic activity moderated in the first half of the year. Job gains have slowed, and the unemployment rate has edged up but remains low. Inflation has moved up and remains somewhat elevated.”

The central bank’s revised rate outlook, released yesterday as part of new economic projections, anticipates the median Fed funds rate (at 4.125% after yesterday’s cut) will continue sliding. The ”projected appropriate policy path” for the target rate for 2025 is 3.6%, slipping further to 3.4% for 2026 – moderately below the current 4.125% median.

Fed funds futures are pricing in another ¼-point cut at the next policy meeting on Oct, and a repeat performance is expected for the December meeting. By the end of the year, futures are pricing in high odds that the target range will drop to a 3.50%-to-3.75% range, in line with the Fed’s current outlook.

The Treasury market also sees more rate cuts brewing, based on the policy-sensitive 2-year Treasury yield. Although this widely followed rate rose sharply yesterday to 3.57%, it remains well below the current median Fed funds rate – a gap that suggests the market is still expecting rate cuts.
 

A simple model that compares the current median Fed funds rate to the sum of the unemployment rate and the annual pace of headline consumer inflation (a proxy for monitoring conditions re: the Fed’s dual mandate) suggests that policy is still modestly tight. In turn, that leaves room for another rate cut to align policy with a neutral level vs. current economic conditions.
 

A possible joker in the deck is the risk that inflation will continue to edge up – a risk that Fed Chairman Powell noted in his press conference yesterday:

We have begun to see goods prices showing through into higher inflation, and actually the increase in goods prices accounts for most of the increase in inflation, or perhaps all of the increase in inflation over the course of this year. Those are not very large effects at this point, and we do expect them to continue to build over the course of the rest of the year and into next year.

For now, the Fed sees the slowdown in hiring as a bigger threat. “It’s really the risks that we’re seeing to the labor market that were the focus of today’s decision,” Powell explained.

But as I discussed yesterday at TMC Research, the rise in core consumer inflation in recent months, based on the annualized 3-month change, could be a warning sign that pricing pressure will accelerate further. If so, expectations for more rate cuts may be premature.
 

For the moment, markets are still pricing in more rate cuts. The question is whether incoming inflation numbers will persuade the crowd to reprice expectations?

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