Market selloff upends Fed rate-cut calculus

Fed officials don’t meet again until Sept. 17-18. There, they could debate whether to kick off their widely anticipated sequence of rate cuts with a larger reduction of a half-percentage point, or 50 basis points, if last month’s weak-across-the-board employment report is indicative of a new, worrisome trend.

But slashing policy rates before then, in between scheduled policy meetings, would be very unusual. Those moves are generally reserved for notable deteriorations in market functioning that go well beyond an equity-market swoon.

“They have a really high bar for that," said Steven Blitz, chief U.S. economist at GlobalData TS Lombard. “I think what they would rather do is go out and say, ‘If things continue the way they are, 50 basis points in September is on the table.’"

At a news conference last week, Fed Chair Jerome Powell suggested officials were on track to lower rates by a quarter-percentage point next month. That was before the Labor Department reported on Friday that U.S. hiring cooled and the unemployment rate rose by more than expected in July, which fueled bets on a supersize half-point cut.

Then on Monday, a stampede to exit popular investment strategies that borrowed cheap Japanese yen to buy stocks accelerated a market downdraft in Asia. That led some panicked investors to speculate about the Fed cutting in between scheduled policy meetings. The unwinding of those so-called carry trades began last month but gathered speed after the Bank of Japan raised interest rates last week.

Still, the Fed will not “want to respond too quickly to something happening over a few days’ time, when it could reflect positioning or other developments in markets that could later be unwound," said Matthew Luzzetti, chief U.S. economist at Deutsche Bank.

There are reasons to think the increase in the unemployment rate, which climbed to 4.3% in July from 4.1% in June, had been driven by less concerning factors, said San Francisco Fed President Mary Daly on Monday. For example, it reflected an increase in temporary as opposed to permanent layoffs.

The Fed “is prepared to do what the economy needs when we are clear what that is, and there’s many more pieces of information that come out between now and when we next meet," she said during a question-and-answer session in Hawaii.

The S&P 500 fell 3%, or 160.23 points, the largest one-day decline since September 2022. But bond investors, who at one point bet big on rate cuts, changed their minds later in the day. The policy-sensitive 2-year Treasury yield fell by 0.22 point early Monday and then reversed course, ending the day at 3.880%, virtually flat. (Yields fall when bond prices rise.)

A report on service-sector business conditions on Monday also calmed nerves about a rapid economic slowdown when the Institute for Supply Management reported its index rose 2.6 points to 51.4 in July. A reading above 50 indicates expansion.

The market moves suggested there wasn’t a big flight to safety occurring, as often happens when investors grow more worried about deteriorating economic fundamentals, analysts said. Conditions instead suggest more technical drivers of a selloff that deepened late last week, including the unwind of crowded trades in Japanese stocks and large technology companies.

Lofty stock prices and steady income and job growth have been critical engines of an economic expansion whose resilience has baffled economists. A sustained downturn in the stock market could shift the outlook for the U.S. economy if it leads companies to slash investment plans or lay off workers. But it could take days or weeks to judge how any selloff reshapes the outlook.

Even though the Fed doesn’t meet for six more weeks, Powell has an opportunity to weigh in on the evolving outlook later this month. Powell has often used a widely watched speech at the beginning of a Fed conference in late August as a venue to frame the central bank’s broad outlook. That conference, in the iconic Grand Teton Mountains of Wyoming, is set to begin on Aug. 23, and economic and market developments over the next three weeks could shape any remarks.

Last week, “the whole Fed committee was working on the assumption that the economy is going to look in September the way it did last week, and you could do the usual slow shuffle" to cut rates, said Blitz. “The markets are speaking to the Fed. They’re telling the Fed, ‘You’re too tight, and no, you can’t presume that everything is going to roll along merrily while you take your time to cut.’"

The Fed raised its benchmark federal-funds rate most recently in July 2023 to a range between 5.25% and 5.5% to combat rising prices. Inflation has slowed notably over the past year.

The latest market reaction is notable because just a few months ago, some investors feared that the Fed might not have raised rates to a sufficiently high level to subdue inflation. Officials have been reluctant to lower rates before they see more evidence that price pressures won’t reignite.

Expectations of slower economic growth, cooler inflation and Fed rate cuts could begin to help rate-sensitive parts of the economy over the coming months. The average 30-year fixed-rate mortgage dropped to 6.34% on Monday, according to Mortgage News Daily, down from 6.81% one week ago and the lowest since April 2023, when worries about potential regional-bank insolvencies led to a bond-market rally.

Borrowing costs often ease in anticipation of future rate cuts. As a result, rate reductions in between scheduled policy meetings are reserved for times when financial markets face more acute strains from a rapidly deteriorating outlook or when the Fed wants the element of surprise to deliver its own signal. Since Powell became Fed chair in February 2018, the central bank has cut rates in between policy meetings twice, with both occurring in March 2020 as the Covid-19 pandemic spread.

Outside of that episode, rate cuts in between meetings have occurred during the following periods:

In October 1998, the Fed cut rates just weeks after an initial reduction to prevent a market meltdown after the implosion of Long-Term Capital Management, a large hedge fund.In January 2001, a monthslong downturn in technology stocks was followed by worsening economic data, leading to a surprise half-point cut.The Fed had cut rates by 1 percentage point through the fall of 2007, but economic deterioration and a massive trading loss at a French investment bank prompted the Fed to slash rates by 0.75-point in January 2008, one week before a scheduled policy meeting.

Write to Nick Timiraos at Nick.Timiraos@wsj.com