The latest meeting notes and comments from the Fed mean interest rates are once again making headlines. Questions abound: Will the Fed cut rates—or not? If so, when? And by how much? Some believe that surely the Fed has to cut rates and that means markets will be going up!
What does the Fed have to say about all this? In fact, the Fed has not done anything to support these ideas, apart from some mildly encouraging comments on the progress in pulling inflation down. Still, markets have bought into the idea that the Fed will be cutting, by a lot, over the course of 2024. We see evidence of this in the market response, as the yield on the U.S. Treasury 10-year is back down to levels last seen several months ago.
Indeed, we have seen this movie before. Several times in the past couple of years, markets have talked themselves into believing the Fed had to cut, only to find out that the Fed didn’t have to cut—and didn’t cut. I suspect we will find the same situation over the next several months.
Breaking Down the Fed’s Mandates
To understand why, let’s think about why the Fed really would have to cut. It has two responsibilities: to keep inflation low (at 2 percent, so it says) and to keep employment high (with no specific goal). Right now, the job market may be slowing, but it is still very strong. There are about 3 million more job openings than there are unemployed people. We would have to see the job market weaken considerably before the Fed would even think about cutting rates, and that would likely take at least six months. So, the employment mandate certainly isn’t showing a need for a cut and won’t into the middle of next year at least.
The second mandate, keeping inflation low, also doesn’t argue for a cut. Inflation is down—the Fed’s preferred measure, personal consumption expenditures (PCE), came in this week lower than expected—but it is still well above target. And another measure the Fed watches, inflation expectations, is ticking up. At best, the data argues for a pause in rate increases and not a cut. A pause is what the Fed commentators have been hinting at. A pause would be good, but it isn’t a cut much less several cuts.
Arguing for a Cut
Beyond the Fed’s statutory mandates, there are other reasons to argue for a cut. One is that as inflation declines, the real rate of interest (the nominal rate less inflation) will increase, which is true enough, and will choke off growth. Again, the data doesn’t show it as last quarter’s growth was just revised up to a multiyear high. At some point that may happen, but not this year. So, the economic data and the Fed’s statutory mandates don’t support cuts any time soon, at least into the middle of next year and probably longer.
Staying the Course
Even beyond the immediate situation and data, there are reasons to believe rates will stay at current levels indefinitely. The first is the Fed’s own institutional needs. One of the drawbacks of very low rates is that there is little room to cut when we do see a recession. With rates back to historically normal levels, why would the Fed waste this valuable maneuvering room until we do have a recession? The second is history, which shows that rates have almost always been in the current range or even a bit higher—and the economy has done just fine. Third is simply the Fed’s priorities. As long as employment is healthy, the Fed is free to focus on inflation, which is just what we have seen.
So, the economy is doing fine and doesn’t need rate cuts. Inflation is better but still not at target, so certainly doesn’t need a rate cut. The Fed likes to keep its powder dry for a recession until one shows up and won’t cut until then. And looking forward? There is no recession in sight.
Volatility Ahead?
Absent a serious deterioration in the economy, which is certainly possible but not what we see today, I am not expecting any cuts next year. Markets are currently pricing in those cuts and are likely to be disappointed, which should kick off more volatility. At the same time, earnings should continue to grow as the economy remains healthy. Overall, conditions should remain favorable but expect volatility around rate expectations.
The short version is this: rates are about where they should be—and that is just fine for the economy and markets.
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