The most significant event this autumn might not be the US election, a conflict in the Middle East, or even the World Series. For many Americans, it will be the first reduction in US interest rates in over four years. While the anticipated rate cut by the Federal Reserve in mid-September won’t immediately impact the cost of goods or hiring decisions, it will mark the beginning of a new phase in the monetary policy cycle with far-reaching implications for the economy, financial markets, and consumers.
If the Fed eases too little during this cycle, the economy could slip into a recession. On the other hand, cutting rates too quickly could reignite inflation and lead to speculative market behaviour. However, if Fed Chair Jerome Powell and his colleagues manage to strike the right balance, they could achieve the elusive “soft landing” – keeping the economy growing at a steady rate without the risk of recession or significant inflation.
There is cautious optimism that the Fed might succeed this time. Powell’s keynote address on 23 August at the Fed’s annual Jackson Hole Monetary Policy Symposium is expected to set the stage for the upcoming rate changes. This shift is being driven by a slowdown in inflation towards the Fed’s 2% annual target over the past two years, along with a desire to stay ahead of a weakening labour market. Powell is likely to emphasise that the Fed’s decisions will continue to be data-driven while confirming a dovish stance among policymakers.
July’s readings for the consumer and producer price indexes have laid the groundwork for another mild inflation report on 30 August, when the government releases the personal consumption expenditures price index, the Fed’s preferred inflation measure. The year-on-year CPI inflation rate fell to 2.9% last month, the first time it has dipped below 3% since the Autumn of 2021. Recent monthly figures suggest an annual inflation rate of 2% or less if current trends continue. The jobs and inflation reports for August, due in early September, will be the last major economic data before the Federal Open Market Committee meeting on 17-18 September. Markets are currently betting on a 25 basis point cut at that meeting, which would lower the federal funds rate to a target range of 5.00%-5.25%.
The Fed last cut rates in March 2020 at the onset of the COVID-19 pandemic, bringing them down to 0%-0.25%. It then embarked on a rate-hiking cycle in March 2022 to curb inflation, which peaked later that year at 9% year-on-year. In total, the Fed raised rates 11 times, reaching a target range of 5.25%-5.50%, where they have remained since July 2023. With a September rate cut almost certain, attention on Wall Street is shifting to the trajectory of the easing cycle. The Fed’s June Summary of Economic Projections suggests a quarter-point cut per quarter through the end of 2026, culminating in a longer-term fed funds rate of 2.8%. However, futures markets are pricing in a more aggressive easing cycle, with expectations of a full percentage point of cuts by the end of 2024, followed by another percentage point in 2025.
The course of the rate cut cycle will largely depend on the reason for the Fed’s actions. If the Fed is cutting rates to rescue the economy from a recession, the easing could be more significant. Conversely, if the goal is merely to normalise rates that have become too restrictive, the cuts could be more measured. The so-called neutral rate of interest – a rate that neither stimulates nor restricts economic activity – would be the end point in a normalisation scenario. Estimates of this neutral rate today range from 3% to 3.5%, higher than pre-COVID levels.
Interest rate expectations have been highly volatile this year, fluctuating with nearly every data release or Fed announcement. More twists and turns are expected before 2024 comes to a close.
In January, futures markets were predicting more than 1.5 percentage points of rate cuts in 2024 based on the prior quarter’s slowdown in price growth. By Autumn, following a series of high inflation reports, many market participants doubted there would be any rate cuts this year. But by August, with inflation easing and job growth slowing, markets once again anticipated a series of cuts through the spring.
The economy, while cooler than its overheated post-pandemic state, remains strong: jobs are still plentiful, consumer spending is robust, and economic output continues to grow. Real US GDP increased at a 2.8% annualised rate in the second quarter, and the Atlanta Fed’s GDPNow estimate projects 2.0% growth in the third quarter.
The labour market remains relatively healthy, despite a slight uptick in the unemployment rate to 4.3% in July from 3.4% in April 2023. This increase is primarily due to a growing labour pool rather than layoffs. Powell has expressed that the current state of the labour market is unlikely to generate significant inflationary pressures, but the Fed is motivated to pre-empt further labour market weakness by cutting rates before unemployment rises significantly.
The Powell Fed, having faced criticism for being slow to hike rates at the start of the cycle, is likely mindful of the reputational risk of being too slow to cut them now.
