Fed (FOMC) Meeting Preview: 25 bps Cut Appears Baked In, Forward Guidance Is Key. Implications for the DXY, Dow Jones and S&P 500

[Ben Graham]

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The Federal Reserve's upcoming meeting is a big deal for the US economy and financial markets as a whole.

The latest economic data suggests the Fed should start lowering interest rates. However, the market already expects a rate cut and based on market moves it appears that it has largely been priced in.

Because of this, the Fed's announcement about their future plans will likely be more important than their actual decision at this meeting. That is likely to be what will really stoke volatility barring a surprise decision by the Fed.

Source: CME FedWatch Tool

The Macroeconomic Case for a Rate Cut

The main concern is the weakening job market. While the economy grew by 3.3% in the second quarter, this was mostly due to a big change in trade, which hid the fact that consumer spending was weak. People were spending less because they were worried about tariffs, a cooling job market, and unstable wealth.

This was confirmed by the Federal Reserve's Beige Book, which showed little to no economic activity and declining consumer spending across the country. It also reported that most districts were not hiring and that the job market was slowing. Last Friday's jobs report also showed a small increase in jobs, and unemployment went up. Revisions to job numbers from the past year showed the economy created less than half the jobs that were previously reported.

Even though inflation is still above the target, the risk to the job market now seems more urgent to the Fed. They'll likely start to move toward a less restrictive policy.

Three factors that drove inflation up in 2022—oil prices, housing rents, and wages—are now gone, and are even helping to lower inflation. A cooling economy with rising unemployment will also help bring inflation back down to 2% by the end of 2026.

The Fed will probably lower its forecasts for economic growth and inflation while raising its unemployment projections. We expect the Fed to cut interest rates by 0.25% at their September 17 meeting, with more cuts to follow in October, December, January, and March. It's possible the Fed could start with a larger cut of 0.50%, but a 0.25% cut is more likely because most members are still cautious about the impact of tariffs on inflation.

The Fed's Challenge: Reining in Dovish Expectations

The Federal Reserve is in a tough spot. Even with evidence pointing to a need for lower interest rates, the market has already bet on a lot of rapid rate cuts. This creates a significant communication challenge for the Fed. They have to manage market expectations very carefully.

The "Dovish" Surprise

One possibility is that the Fed tries to meet or even beat the market's high expectations. Traders are already anticipating a lot of cuts by the end of 2026. For the Fed's announcement to truly be a positive surprise for the market, they would need to signal an even faster pace of rate cuts than what is already expected. If they simply use their normal cautious language, even when announcing a cut, the market might see it as a disappointment. The real risk here isn't a wrong policy decision, but a gap between what the Fed says and what the market wants to hear.

The "Powell Pushback"

A different view is that Fed Chair Powell will intentionally try to lower market expectations. This perspective suggests that he will push back against the idea of quick rate cuts in October and December. Instead, he would likely emphasize that the Fed will continue to be guided by incoming economic data, keeping their options open.

This cautious approach is about protecting the Fed's credibility. Having been criticized for underestimating inflation in the past, they don't want to cut rates too soon only to have to reverse course if inflation spikes again. By remaining patient and focusing on data, Powell would be protecting the Fed's reputation and ensuring they can react to the economy as it unfolds, rather than being forced into a schedule set by the market

Probable Scenarios and Forward Outlook

Source: Google Gemini

Impact Analysis on US Indices and Broader Markets

The market's reaction to the FOMC meeting will translate the two primary scenarios into tangible consequences for US indices and other asset classes.

The reaction to a dovish signal would likely be a boon for equities. The S&P 500 would likely rally, driven by the anticipation of lower borrowing costs and a broader "risk-on" sentiment. The Nasdaq 100, composed of technology and growth stocks, would likely outperform due to its higher sensitivity to changes in interest rates.

Conversely, a hawkish signal would be a source of disappointment for "doves," potentially triggering a pullback in US indices as traders unwind their aggressive rate-cut bets. Tech and growth stocks would be particularly vulnerable. The following table summarizes the potential impact on key US indices and the U.S. Dollar Index (DXY) under the two scenarios.

Source: Google Gemini

Since the market is already highly dovish, the disappointment of a cautious Fed is significant. A potential sell-off might be sharp, but it could also be short-lived if the underlying macroeconomic data remains fundamentally sound. A cautious hold today might simply be a delay of an inevitable cut tomorrow. This understanding is critical for long-term investors aiming to distinguish between temporary market volatility and a fundamental shift in economic trajectory.

Tomorrow's meeting promises fireworks regardless of the decision. Volatility will definitely rear its head and the decision could have wider implications for global markets and risk sentiment.

For more on tomorrow's meeting and what to look out for, read Guide to the FOMC statement and September SEP: Key takeaways and what to watch

Trade Safe.

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