The Market Is Betting on an October Rate Cut. Some Fed Officials Aren’t So Sure.

Alberto Musalem, president of the Federal Reserve Bank of St. Louis, said central-bank officials need to “tread cautiously.” (Kent Nishimura/Bloomberg)

Federal Reserve officials are pushing back on the idea that another rate cut is inevitable next month. Markets aren’t buying it, based on trading of federal-funds futures. The widening gap between policymakers and investors could indicate a possible market reckoning come October.

At the center of the tension are rising prices. While inflation has slowed from its pandemic highs, it remains above the Fed’s 2% target. Several regional Fed presidents cautioned on Monday that policymakers shouldn’t move too quickly to ease policy, even as investors and Wall Street analysts bet on more cuts.

The Fed lowered its federal-funds rate target range by a quarter of a percentage point in September, to 4.00%-4.25%, its first rate reduction this year.

St. Louis Fed President Alberto Musalem said on Monday that while he hasn’t shut the door to another interest-rate hike, policymakers need to tread cautiously.

“I’m open minded to future potential reductions in interest rates,” Musalem said at Washington University in St. Louis. “I do believe we need to tread cautiously because the room between now and the point where policy could become overly accommodative is limited.”

Policymakers, said Musalem, should “lean against” inflation that sits above the target range. Headline inflation ticked up by 2.7% year over year in August, and core inflation, excluding food and energy prices, rose 2.9%, based on the latest reading of the personal consumption expenditures price index, released Friday. The PCE is the Fed’s favored inflation measure.

Cleveland Federal Reserve President Beth Hammack expressed similar thoughts Monday morning. Speaking at the European Central Bank in Frankfurt, she said that inflation has remained above target and the Fed has been “missing our mandate” for 4½ years. “When I look at the trend, it’s in the wrong direction,” she added.

When the central bank cut rates last year, inflation was lower than where it is today and the trend was headed downward. “Over the last year, inflation has largely moved sideways and some components have moved up,” she said.

Inflation, in her view, won’t fall back to that 2% target until the end of 2027.

“I want to be open-minded about where things may head from here,” Hammack said, adding that “we need to maintain a restrictive stance of policy to ensure that we can bring inflation back to target.”

Other officials have been similarly cautious. Kansas City Fed President Jeff Schmid said last week that inflation remains too high and policy is only slightly restrictive.

“My view is that inflation remains too high while the labor market, though cooling, still remains largely in balance,” Schmid said in Dallas on Thursday. “I view the current stance of policy as only slightly restrictive, which I think is the right place to be.”

Richmond Fed President Tom Barkin echoed that confidence, noting that after years of restrained hiring, businesses are less likely to resort to layoffs. “That means the downside in the labor market should be limited,” he said at the Peterson Institute for International Economics on Thursday.

Chicago Fed President Austan Goolsbee cautioned against overweighting weak payroll prints. Speaking at a breakfast event in Grand Rapids Michigan, he said he was “somewhat uneasy with front-loading too many rate cuts based just on the payroll jobs numbers slowing down.”

Investors remain convinced, however, that easier policy is coming. Futures markets show that nearly 90% expect a quarter-point cut at the Fed’s Oct. 28-29 meeting. About 70% are betting on another cut in December, according to the CME FedWatch tool.

Citigroup economists dismissed the Fed’s tone as overly hawkish, writing Monday that officials are “overestimating upside risk to inflation and underestimating downside risk to employment—and that this will likely become more evident in coming months.”

The divide is also visible inside the Fed. In their latest projections, 10 officials penciled in three cuts this year, while nine expected two or fewer. Fed officials believed to favor more cuts have cited growing weakness in the labor market.

New York Federal Reserve president John Williams said on Monday that the central bank doesn’t want to cause “undue harm” to its mandate of maximum employment.

Governor Michelle Bowman warned last Thursday that the Fed risks falling behind the curve on jobs. The labor market remains “fragile,” she said.

Newly sworn-in Governor Stephen Miran also said last week that the longer borrowing costs remain elevated, “the greater the risk to the economy that you really do start to get material increases in unemployment.”

The Fed will have fresh inflation and September jobs data before its late-October meeting—although a government shutdown could delay important releases, adding more uncertainty to an already clouded outlook.

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