Fed rate cuts are coming, but investors disagree on the path forward

Markets might be running ahead of themselves by pricing aggressive Federal Reserve interest-rate cuts this year.

According to CME Group data, investors are mostly pricing a 25-basis point cut in each of the next two Fed meetings in September and November, followed by a larger trim in December, which some analysts and investment managers say would be too aggressive as they have concerns about a slowdown in economic growth.

The debate has implications for central banks around the world. If the Fed follows the more gradual route and cuts in 25-bp. increments, U.S. interest rates will remain high relative to other countries for longer. That, in turn, would attract investors to dollar-denominated assets, strengthening the U.S. currency.

On the other hand, a more aggressive easing cycle in the U.S. could give more room for other central banks to also trim their own rates without weakening local currencies.

Last week at Jackson Hole, Fed Chair Jerome Powell gave clear signals the Fed is ready to cut rates in September, while clarifying that the Fed does not seek or welcome further cooling in labor-market conditions.

“We now expect 25bp cuts at every meeting this year,” analysts at BNP Paribas Markets 360 said. However, considering Powell’s dovish pivot, they see “a relatively low bar for a 50 basis point move.”

The Fed is tasked with ensuring price stability and promoting maximum employment. It targets a 2% annual inflation rate. On Friday, its preferred gauge, the PCE inflation index, is expected to be at 2.5% in the 12 months through July, according to a Wall Street Journal survey, keeping the door open for monetary easing.

The argument for more aggressive cuts stems from a cooling labor market. Unemployment in July was a higher-than-expected 4.3% and past job-creation figures were revised lower last week. Some pundits warn that unemployment could accelerate fast if the Fed takes the cautious approach.

Powell was careful not to rule anything out, said Colin Finlayson, co-manager of Aegon Strategic Bond Fund at Aegon Asset Management.

“While the tone was more on the dovish side, it did little to resolve the conundrum over whether the Fed will open with a 25 or 50 basis point cut in September. The door is open to either but the current data set feels more consistent with a 25bp move,” he said.

In particular, August labor-market data due on Sept. 6 could be decisive if it corroborates July’s sharp slowdown in the pace of job additions.

“Although the Fed likes to say it is ‘data- and not data-point-dependent,’ the August employment report released on 6 September will likely be significant in the ’25 versus 50’ discussion at the next meeting,” said Richard Clarida, global economic advisor at Pimco, and former vice chair of the Fed between 2018 and 2022.

Pimco expects the Fed to cut rates by at least 25bps next month and signal that at least two more cuts of the same size are expected at the remaining two meetings this year in November and December, Clarida said.

The market is continuing its search for the ideal pricing of a U.S. macroeconomic situation amid ambivalent signals from various indicators, analysts at Natixis said.

The easing is expected to continue next year, with the Fed’s target for the fed funds rate ending 2025 at 3%-3.25% range, down from the current 5.25%-5.50%, according to CME.

Write to Emese Bartha at emese.bartha@wsj.com and Paulo Trevisani at paulo.trevisani@wsj.com