Opinion | Why we better not count on US interest rate cuts this year

Opinion | Why we better not count on US interest rate cuts this year

Opinion | Why we better not count on US interest rate cuts this year

At the end of 2023, bond markets were pricing in 1.5 percentage points worth of monetary easing this year, with the first reduction expected in March. By the end of last month, however, the timing of the first cut had been pushed back to June. Following the publication of the stronger-than-expected data, the odds of a June cut fell to 50-50. Indeed, markets now expect slightly less monetary easing this year than the Fed itself, data from Bloomberg shows.

Investors have consistently misjudged the timing of US rate cuts. According to a Deutsche Bank report last November, markets have priced in a dovish pivot by the Fed at least seven times, only to scale back their predictions about the timing and magnitude.

This begs the question of whether the Fed will actually reduce rates this year. At the end of 2023, when America’s central bank signalled that it was done tightening policy, the suggestion that borrowing costs would remain unchanged this year seemed preposterous.
A worker walks past mixing tanks at the Advanced Nano Products battery facility in Elizabethtown, Kentucky, on March 28. US factory activity expanded in March, for the first time in since September 2022. Photo: Bloomberg

Not only had inflation fallen sharply – the core rate, which strips out volatile food and energy prices, stood at 3.9 per cent last December, down from 5.7 per cent at the end of 2022 – fears of a recession or a sharp slowdown lingered, partly because of concerns that the Fed would keep policy too tight for too long.

Fast-forward three months and the possibility that the Fed will not cut rates this year is being taken more seriously. Torsten Slok, chief economist at Apollo Global Management, is the most prominent Fed watcher to make the case for no cuts in 2024.

In a provocative report on March 1, Slok said that “the Fed will spend most of 2024 fighting inflation”, pointing out: “The economy is not slowing down, it is reaccelerating.” Other economists note the Fed has become more divided over the pace of easing. On March 22, Franklin Templeton noted that just under half the Fed’s policymakers expected borrowing costs to be cut by half a percentage point or less this year.

It is clearly becoming more difficult for the Fed to justify easing policy. First, the long-anticipated recession has still not materialised. Instead, the economy has picked up steam, powered by a remarkably resilient labour market, with unemployment below 4 per cent.

Generous pandemic-induced stimulus and a flexible jobs market have helped underpin relatively brisk growth. The private sector added 184,000 jobs last month – the biggest monthly gain since last July – while wage growth for those who changed jobs increased at an annualised pace of 10 per cent.

Second, inflation is coming down at a slower pace, and by some measures is reaccelerating. The Fed’s preferred gauge of inflation – the so-called core personal consumption expenditures price index – has gained momentum in recent months, standing at 3.5 per cent in the first quarter. This lends weight to the view that the last mile of the Fed’s battle against inflation is the hardest.

A customer looks at fresh produce at an outdoor market in Boston, Massachusetts, on March 15. US inflation is lower than a year ago, but coming down at a slower pace. Photo: EPA-EFE
Not long ago, the prospect of borrowing costs staying higher for longer would have rattled markets. Yet, the benchmark S&P 500 equity index has hit 22 fresh all-time highs this year. If rates stay high because the economy is strong, that is no bad thing.

Buoyant growth is good for corporate earnings. Even emerging markets – which have borne the brunt of the Fed’s aggressive tightening campaign due to the surge in the US dollar – could benefit, in particular those more reliant on US demand.

However, there are also risks in keeping rates at high levels. Bank of America warns that financial conditions could tighten sharply if the Fed waits until next year to loosen policy. Indeed, if borrowing costs do not fall by June, the Fed may have little choice but to wait until 2025 because of unfavourable base effects for its preferred inflation gauge in the second half of the year, dubbed “jump risk” by Bank of America.

Fed faces tough 2024 balancing act amid rising deficit, bubble economy

Investors are not prepared for a “no cuts” outcome this year. Markets have priced in a soft landing for the US economy whereby inflation continues to decline, the Fed starts to reduce borrowing costs and growth holds up. The Fed would also like to have the best of both worlds, quashing inflation without inducing a recession.

Many investors believe it can square the circle. Yet they should be careful what they wish for. If the Fed cuts rates while inflation is still fairly high, further tightening may eventually be required. Indeed, given how sticky prices are, significant easing is only likely to occur if the economy slows sharply, something Donald Trump would relish as he attempts to reclaim the White House.

Nicholas Spiro is a partner at Lauressa Advisory

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