Fed interest rate decision imminent: Surprise or predictability?

The debate over the extent of the forthcoming interest rate cut by the Federal Reserve is reaching its peak. In a late twist, the pendulum seems to be swinging in favor of a 50-basis-point cut, significantly ahead of the also-discussed 25-basis-point reduction. For about a month now, the prevailing thought has been that a larger rate cut could lead to panic in the markets. However, in the world of financial markets, it's all about expectations. Panic usually occurs when something unexpected happens. The Fed, which deliberately distances itself from daily market fluctuations, is therefore unlikely to introduce major surprises. "I think the Fed would be cautious about surprising the market," said Matthew Luzzetti, Chief US Economist at Deutsche Bank, in an interview with Yahoo Finance. Currently, markets are indicating a 61% probability of a 50-basis-point rate cut at the next Federal Reserve meeting, as shown by the CME FedWatch Tool. Under such conditions, a shock scenario due to a larger rate cut seems hard to imagine. In fact, a Fed decision in favor of a 25-basis-point cut could be perceived as a tightening of financial policy, considering the current market pricing. "Unless there are changes, a 25-basis-point cut will tighten financial market conditions and push interest rates higher," said Neil Dutta, Head of Economics at Renaissance Macro, in a client note. A tightening of financial conditions should be avoided, especially when the risks to employment growth outweigh the inflation risks. Gregory Daco, Chief Economist at EY, expressed similar sentiments on Yahoo Finance's "Catalysts." "People say 25 basis points don't make much of a difference," said Daco. "But the risks are asymmetric. If the Fed doesn't ease monetary policy as much as the markets expect, there will be a revaluation of interest rates, with upside potential in rates." These movements could impact consumption and economic sentiment, which could have a negative effect on the overall economy, Daco added. According to a note from David Kostin, Chief US Equity Strategist at Goldman Sachs, his team sees the S&P 500 at 6,000 points over the next 12 months, provided the Fed's actions can support the current growth story of the US economy. "While some investors believe the speed of Fed cuts will be the key factor for stock returns in the coming months, growth is ultimately the most important driver for the stock markets," wrote Kostin. If the Fed indeed needs to cut by 50 basis points to secure growth forecasts and avert a recession, then so be it. The markets already seem to be anticipating this possibility.