The Federal Reserve is about to make a difficult decision, will the market be embarrassed again?

Investors are facing a trillion-dollar question, that is, whether the Federal Reserve will cut the federal funds rate by 25 basis points or a full 50 basis points at the Federal Open Market Committee (FOMC) meeting scheduled for this week. This will be the first rate cut by the Fed in over four years.

According to data from the CME FedWatch tool, the calls for a significant rate cut are increasing, with 60% of Wall Street traders predicting a 50 basis point cut by the Fed. In addition, the futures market expects the Fed to cut rates by at least 100 basis points this year.

Market veteran Nilesh Shah warns investors that since mid-2023, market expectations for the Fed's rate path have often been wrong.

He said, "People had expected the first rate cut to be in mid-2023, and my feeling is that this time the market will also be wrong in predicting the Fed's rate cut prospects. Our feeling is that the actual rate cut by the Fed will be lower."

Respondents surveyed by CNBC also predict that the Fed's rate cut cycle this time will be more gradual than what is currently priced in the market.

The survey shows that out of 27 respondents including economists, fund managers, and strategists, 84% believe the Fed will cut rates by 25 basis points, while 16% believe it will be a 50 basis point cut.

The main reason for the discrepancy between respondents and market expectations seems to be that the former appear to have less concern about the overall economy and have more faith in the Fed having time to gradually cut rates. 74% of respondents said the rate cut in September came at the right time, with only 15% saying it was too late.

David Doyle, chief economist at Macquarie, said, "While the Fed could make a larger rate cut, our base expectation is for a 25 basis point cut at this meeting, totaling 200 basis points by next year."

What would trigger a larger rate cut?

Macquarie's global foreign exchange and rate strategist Thierry Wizman and others stated that the only reason for a 50 basis point cut would be if a financial crisis erupted in the days leading up to the FOMC meeting, but with less than 24 hours until the meeting concludes, this seems unlikely.

Some experts warn that a 50 basis point cut could spook the market, attributing a larger-than-expected rate cut to the Fed's attempt to overcome imminent economic turmoil. However, not everyone agrees that the Fed needs to act urgently.

Renowned economist Claudia Sahm is one of those dissenting voices.

Sahm is best known for creating the eponymous recession indicator, which was triggered after the July nonfarm payroll data was released.

In a recent blog post, Sahm outlined the reasons for a 50 basis point cut, emphasizing "progress in inflation alone proves that the start of the Fed's easing cycle is reasonable and provides a reason for a 25 basis point cut. The additional 25 basis point cut is due to the labor market cooling faster than expected." "Labor market has not remained strong," Sam wrote. "Disappointing labor market data since the July FOMC meeting should increase the rate cut by 25 basis points."

Neil Dutta of Renaissance Macro Research also refuted criticisms that a 50 basis point rate cut would cause market panic, stating that only a 25 basis point rate cut would trigger real risks. In a report to clients on Monday morning, he wrote:

"A 25 basis point rate cut is actually still a tightening of financial market conditions. Monetary policy operates through financial markets. When the balance of risks between growth and inflation shifts as it has now, tightening financial conditions should be avoided. If the downside risks to employment outweigh the upside risks to inflation, then all else equal, the Fed should lean against tightening financial conditions."

What matters most to the market?

Regardless of whether the Fed chooses to cut rates by 25 basis points or 50 basis points, the most important factors influencing market trends will be Powell's rationale for announcing the rate cut and the updated dot plot.

Shibani Sircar Kurian of Kota Mutual Funds stated, "If the Fed cuts rates because inflation has slowed, growth has slowed but not fallen off a cliff, and this is a slow and steady rate-cutting cycle, it will be positive for the stock market. However, if the rate-cutting cycle accelerates due to an economic recession, it will be negative for the stock market."

Kurian added that the Fed is walking a tightrope before the November U.S. presidential election. On one hand, they need to cut rates to support the economy, but they do not want inflation to come back.

David Kostin, Chief U.S. Equity Strategist at Goldman Sachs, wrote that his team expects the S&P 500 index to reach 6,000 points in the next 12 months, with the success of this target entirely dependent on whether the Fed's actions can maintain the current soft landing narrative.

"While some investors believe the pace of Fed rate cuts will be the key determinant of stock market returns in the coming months, the growth trajectory ultimately remains the most important driver of the stock market," Kostin wrote