Expectations of Another Fed Rate Hike This Month Are Shifting Dramatically

Expectations of a second interest rate hike by the Federal Reserve at its Oct. 27-28 meeting are suddenly plummeting. As recently as Sept. 28, the futures market put the probability of a rate hike this month at 71%. Today, futures traders are pricing in just a 20% probability that the Fed will hike. What gives?

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So, what happened?

Well, first of all, the September employment report, published on Oct. 2, was much weaker than expected. Economists expected the economy to add at least 84,000 new jobs during the month, yet the actual figure was just 29,000. In addition, the unemployment rate ticked up a notch, from 4.1% to 4.2%.

That suggests the labor market is weakening. So the Fed, which has a mandate to maximize employment, might be more reluctant to raise rates, a move that can slow the economy and undermine job creation.

Also, there are signs that inflation, which has been above the Fed's target level for several years, might be cooling a bit. The personal consumption expenditures price index, which is the Fed's preferred measure of consumer inflation, rose 3% year over year, when food and energy prices are excluded. That was down from 3.3% the previous month.

And annual wage growth slowed slightly. Wage growth is an important aspect of inflation, and one that the Fed monitors very closely.

The Fed is voicing a dovish approach to rate hikes

Finally, the Fed itself is sounding more dovish. New York Federal Reserve President John Williams said in a Sept. 29 speech that "there is no need for urgency" on the next rate hike and that the Fed has time to gather more information about what's going on in the economy.

So, the Fed appears to be taking a very gradual approach to raising its target interest rate. That's very good for the stock market, as research on how the market reacts to rate hikes has shown that the pace of a hiking cycle matters a lot. One study by the brokerage Charles Schwab looked at rate hikes going back to 1946 and found that when the Fed moves quickly on hikes, the market is down, on average, 16.5% 12 months after the first hike. When it goes slowly, the market drawdown shrinks to 12.2%.

Schwab says it doesn't expect an aggressive tightening campaign by the Federal Reserve, and I agree. I've monitored all of Fed Chair Kevin Warsh's comments since he took the helm at the central bank, as well as some of his colleagues, and it all suggests that the Warsh-led Fed wants to move gradually and deliberately, closely monitoring all the economic data on inflation, economic growth, and the labor market along the way.

Charles Schwab is an advertising partner of Motley Fool Money. Matthew Benjamin has no position in any of the stocks mentioned. The Motley Fool recommends Charles Schwab and recommends the following options: short September 2026 $95 calls on Charles Schwab. The Motley Fool has a disclosure policy.