The Shutdown Leaves the Fed Flying Blind. Don’t Be So Sure About Rate Cuts.

Traders are certain the Fed will cut rates at the meeting later this month. (Michael Nagle/Bloomberg)

Key Points

• Investors anticipate a 95% chance of a quarter-point rate cut by the Federal Reserve in October, up from 52% a month ago.
• The government shutdown has delayed key economic data, including the September jobs report.
• Despite signs of labor market weakness, inflation remains above the Fed’s 2% target, with PCE at 2.7% and core inflation at 2.9% in August.

Investors are all but certain the Federal Reserve will cut interest rates again this month. But policymakers are signaling the path ahead may be rockier than traders anticipate, and the government shutdown further darkens the trail.

Investors are now pricing in a 95% chance of a quarter-point rate cut at the Fed’s Oct. 28-29 meeting, according to the CME FedWatch tool. That is up from just 52% one month ago. Markets also see an 85% probability of another cut in December, bringing rates to 3.50%-3.75% by year-end.

The Fed cut its benchmark rate by a quarter point to 4.00%-4.25% at its September meeting. At that meeting, policymakers were narrowly split on the rest of the year, with 10 officials projecting two more cuts and nine seeing one or no additional reductions.

The gap between market conviction and policymaker hesitation means markets may be in for a surprise later this month.

Several Fed officials have struck a more cautious tone recently, warning that inflation remains stubbornly above the central bank’s 2% target and that the economy may not need as much help as markets believe.

Policymakers are trying to calibrate rates while navigating what Chair Jerome Powell has called a “curious kind of balance.” The labor market is showing signs of weakness, while inflation lingers.

Data that will help officials understand that balance isn’t coming, at least not yet. The government shutdown has closed the Bureau of Labor Statistics and delayed the release of the September jobs report indefinitely.

The shutdown and associated data delays make October rate cuts more likely, said Krishna Guha, head of global policy and central bank strategy at Evercore ISI. That’s because a lack of data means the Fed has no reassurance that the labor market remains on solid ground. In that case, he said, the Fed’s default is to cut rates.

Without the official jobs report, the economic picture has indeed grown murkier. Payroll processor ADP reported that private employers shed 32,000 jobs in September, painting a weaker picture of the labor market than what economists expected. The Institute for Supply Management’s services index fell to 50 in September from 52 in August, teetering on the edge of contraction.

“The abrupt slowdown in the service sector is a warning flag and indicative that the Fed needs to continue to cut key interest rates,” wrote Louis Navillier on Friday, citing deep declines in business activity, new orders, and inventories.

Official jobs data from recent months hasn’t been much better. Nonfarm payrolls have advanced at an average of just 29,000 a month over the past three months. The unemployment rate has crept up to 4.3%, still low by historical standards, but the highest since October 2021.

Yet inflation remains sticky. The personal consumption expenditures index (or PCE), the Fed’s preferred measure, rose 2.7% year over year in August, with core inflation at 2.9% over the same period. Both figures remain above the Fed’s 2% target.

Dallas Fed president Lorie Logan this week warned against expecting rate cuts. She supported the September cut as “insurance against the downside risks to the labor market,” but made clear that further easing isn’t guaranteed.

“The combination of persistent inflation, resilient demand, and modest labor market slack indicates to me that policy is likely only modestly restrictive,” Logan said on Tuesday. “There may be relatively little room to make additional rate cuts without inadvertently moving to an inappropriately accommodative stance.”

Fed governor Philip Jefferson said on Friday that he hadn’t decided whether to cut or pause at October’s meeting. “With respect to the path of the policy rate going forward, I will continue to evaluate the appropriate stance of monetary policy based on the incoming data, the evolving outlook, and the balance of risks,” he said.

But it’s impossible to evaluate data if it doesn’t exist.

Write to Nicole Goodkind at nicole.goodkind@barrons.com