Markets Underpricing Risk of 50bp September Fed Cut

Summary

• Markets are currently pricing only 10% risk of a 50bp Fed cut next week. Before CPI, I think risks are near but below 50%.
• Recent data shows the labour market is weaker than earlier thought as well as rising downside employment risks. Overall, the labour market is in worse shape than a year ago when the Fed cut 50bp.
• This time, inflation risks will weigh on the Fed’s decision. My probability of a 50bp cut would rise above 50% if CPI continues showing that tariffs are unlikely to cause a permanent inflation increase.

Market Implications

Ahead of the CPI, I still expect two-three 2025 cuts.

Weaker Labour Market Than a Year Ago

Markets are currently pricing 1.1 cuts at next week’s FOMC, i.e., only a 10% probability of a 50bp cut. My subjective probability ahead of the CPI is near but below 50% and will rise to above 50% if CPI continues showing limited risks of a permanent inflation increase.

Most recent data confirms labour market and economic weakening I have highlighted in my latest research notes.

The first estimate of the annual benchmark NFP revisions published this week shows non-farm employment up to March 2025 911k lower than current estimates (Chart 1). This is the largest revision in the series’ history and aligns with the bias in the BLS birth and death model I spotlighted in my latest NFP review.

Also, signs of a weakening labour markets have been mounting (Chart 2-6).

Lastly, the GDP growth slowdown is adding downside risks to employment growth. Growth slowed to a 1.4% average in H1 from a 2.3% average in H2 2024. Growth is unlikely to rise from here as policy uncertainty remains high, private sector confidence low, households are deleveraging, and the Trump administration is implementing fiscal consolidation (Charts 7-10).

The labour market and growth backdrop are weaker now (Table 1) compared to when the Fed cut 50bp last September. If not for inflation risks, cutting 50bp would be compelling.

Table 1: Weaker Labour Market and Growth Now Than a Year Ago

Chart 1: Largest Revision in Series’ History	Chart 2: Stable UR for Wrong Reasons
Chart 3: Rising Labour Market Slack	Chart 4: Surplus of Workers Rising
Chart 5: Wage Disinflation Continuing	Chart 6: Real Wages Growth Falling
Chart 7: Still High Policy Uncertainty	Chart 8: Still Weak Private Confidence
Chart 9: Households Deleveraging	Chart 10: Fiscal Consolidation Ongoing

The Fed will weigh employment risks against inflation risks when deciding to cut 25bp or 50bp next week.

Benign CPI Would Lead to 50bp Cut

The Fed is not concerned by the unavoidable tariff-induced increase in prices but rather by risk this price increase becomes a lasting inflation increase. The Fed will be unable to know whether this is happening in real time. Rather, the Fed is looking for signs of a broadening of price pressures which, so far, has not happened.

A key channel of broadening of price pressures would be faster wage growth. If workers could be compensated for the tariff increases and if their employers could pass on the higher wage costs to their customers, a wage-price feedback loop could form and lift inflation. As discussed above, nominal wage disinflation is continuing, and real wage growth is falling.

Consumer prices also show price pressures remain contained. There is no evidence of inflation contagion from tariffed to non-tariffed goods, for instance used cars (Chart 11. Also, the average effective tariff rate has been stable around 10% for the past three months (Chart 12). This could reflect implementation lags or that the administration is quietly reining in its tariff policy, possibly due to voters discontent.

Services inflation shows no sign of acceleration either. Housing disinflation is slowly continuing (Chart 13). Supercore inflation remains roughly stable (Chart 14). Market-based core PCE, which excludes inputted prices and is therefore more reflective of demand pressures, remains stable (Chart 15).

Furthermore, market-based long-term inflation expectations remain stable, another sign tariffs are causing broad-based price pressures (Chart 16).

Sam’s model expects core CPI at 3.1% YoY, aligning with consensus. This could translate into core PCE at 2.9% YoY, below the 3.1% Q4 average included in June’s SEP.

Provided data still shows no inflation contagion from tariffed to non-tariffed goods, continued housing costs disinflation, and a decline in supercore services inflation, the Fed could cut 50bp as these would be further signs the tariff-induced price increases remain contained (Table 2).

A 50bp cut next week would signal the FOMC is lowering its inflation/growth trajectory and would likely see the dots move down, with three cuts in 2025 and two cuts in 2026, from currently two and one, respectively. With a 25bp cut, I expect the dot plot to remain roughly unchanged.

I think Chair Powell would build a consensus among FOMC members largely because the data has so far validated the doves’ view (including Bowman, Waller, Daly and possibly Miran) that the labour market is weakening and the tariffs are likely to have a one-off impact on prices (Table 3). Furthermore, several FOMC members including Williams, Musalem and Kashkari have turned more dovish.

Table 2: Continued Benign Inflation Trends Needed for 50bp Cut (CPI MoM %)

Chart 11: Limited Tariff Impact on Goods Prices	Chart 12: Tariff Rate Has Stabilised
Chart 13: Falling Housing Costs	Chart 14: Supercore Roughly Stable
Chart 15: Stable Market-based PCE	Chart 16: Stable Long-term Inflation Expectations

Market Consequences

Ahead of the CPI, I still expect two-three 2025 cuts.

Table 3: Recent FOMC Members Comments

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