Investors See a Big Drop in Interest Rates in 2025, but Inflation May Be Underestimated

On Tuesday, the U.S. stock market reacted to a July report on producer prices that showed milder-than-expected inflation, easing concerns among investors and reinforcing expectations for significant rate cuts by the Federal Reserve. Market participants are now anticipating a series of interest rate reductions extending into mid-2025, as traders shift their focus away from inflation fears and toward the possibility of an economic slowdown.

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According to the CME FedWatch Tool, traders in the fed-funds futures market are increasingly betting on the likelihood of two full percentage points of rate cuts by July of the next year. This would bring the Fed’s benchmark interest rate down to approximately 3.25% to 3.5%, a significant decrease from the current level of 5.25% to 5.5%. Expectations are also growing for a larger-than-usual half-percentage-point cut during the Fed’s next policy meeting on September 18, with additional easing measures expected by the end of the year.

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Earlier in the year, traders had anticipated multiple rate cuts, but this time, the underlying concern is more about an economic downturn rather than inflation. The prospect of such aggressive rate cuts implies that policymakers believe they can lower rates without reigniting inflation. However, this assumption carries risks, as cutting rates too soon could potentially undo progress in controlling inflation.

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The latest Producer Price Index (PPI) report for July showed a modest 0.1% increase in producer prices, leading some economists to caution against interpreting the data too optimistically. Economists like Stephen Stanley and Paul Ashworth noted that the report included unusual and unpredictable elements, with Ashworth describing the report as "not quite as good" as it appeared. Lauren Henderson of Stifel, Nicolaus & Co. echoed this sentiment, calling the details of the report "uneven." Additionally, over the weekend, Fed Governor Michelle Bowman expressed caution about rate cuts, emphasizing that she still sees potential risks to inflation.

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Despite some signs of progress in the fight against inflation, Henderson and her firm remain cautious, preferring to wait for more data before making any definitive conclusions. Unlike much of the market, Stifel’s base case is that the Fed will likely hold off on cutting rates in September until more comprehensive data, such as Wednesday’s Consumer Price Index (CPI) report and the Personal Consumption Expenditures (PCE) data at the end of the month, are available. Henderson's outlook aligns more closely with Bowman's, as both see upside risks to inflation and do not anticipate a rate cut until the fourth quarter.

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The CPI report for July, scheduled for release on Wednesday, is expected to show the annual headline inflation rate holding steady at 3%, with the core rate slightly lower at 3.2%. The Federal Reserve’s annual Jackson Hole symposium, taking place from next Thursday through Saturday, will provide Fed Chairman Jerome Powell with an opportunity to update his stance on inflation and interest rates before additional data is released.

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The Fed's preferred measure of inflation, the PCE index, is set for release on August 30, followed by the CPI report for August on September 11, just a week before the Fed is widely expected to announce its first interest-rate cut of this cycle. Henderson remains cautious, noting that the first quarter of the year saw three consecutive months of higher-than-expected inflation readings. She pointed out that the Fed has historically struggled to achieve a "soft landing" and has only managed to do so once, in the mid-1990s. Given the challenges of balancing inflation control with economic stability, Henderson believes that the Fed will find it difficult to navigate this delicate situation. However, she acknowledges that this cycle is unique, and Stifel has not ruled out the possibility that the Fed could successfully combat inflation while simultaneously cutting interest rates.

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The upcoming CPI report and the data to be released in September will be critical for traders who are confident that the Fed will begin easing next month. The primary question is whether the rate cuts will be the usual 25 basis points or something more substantial. Economists polled by The Wall Street Journal expect the annual headline and core inflation rates from the July CPI report to remain above the Fed’s 2% target.

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Economist Derek Tang of Monetary Policy Analytics, a firm founded by former Fed Governor Larry Meyer, framed the current dilemma facing the Fed and market participants: "The question now is whether you believe inflation will decline on its own, in which case cutting rates carries no risk and acts as insurance against a recession." If inflation remains stubborn, the Fed can slow down the pace of rate cuts, but the real danger would arise if inflation resurged, making it difficult for the Fed to reverse course.

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Fed officials appear willing to take the risk of cutting rates if it means preserving economic expansion and avoiding a recession. However, there is recognition that more supply shocks could occur, potentially leading to greater volatility in inflation. This uncertainty raises the question of whether the Fed can consistently hit its 2% inflation target or if some flexibility around that level is necessary.

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As demonstrated in the first half of the year, even the expectation of rate cuts can have a significant impact, as seen in May when a rally in stocks created a wealth effect that made it harder to slow consumer demand and bring down inflation. Despite favorable inflation data in May, the Fed was cautious about cutting rates too quickly and emphasized the need for more robust data before taking action.

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At Glenmede, a Philadelphia-based firm with $45.5 billion in assets under management, Michael Reynolds, vice president of investment strategy, noted that the Fed is acutely aware of the risks associated with cutting rates too rapidly. Reynolds believes the Fed's decision to wait until September reflects its desire to gather more data, particularly from two more CPI inflation reports, before making any moves. He suggests that a gradual and methodical return to a neutral rate level would be a sustainable approach, adding that while a recession is not the firm’s base case, the labor market data must be closely monitored as conditions can change rapidly.

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On Tuesday, Treasury yields fell to their lowest levels since August 5, with the 2-year yield, which is sensitive to Fed policy direction, dropping 7.2 basis points to 3.943%. Meanwhile, all three major U.S. stock indexes closed higher, reflecting the market's optimistic outlook in the face of potential Fed rate cuts.

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