Come September, expect rate cuts; says FOMC minutes

22 Aug 2024 , 01:13 PM

GROWTH CONCERNS, NOT INFLATION, TO DRIVE RATE CUT IN SEPTEMBER

There was not much of a surprise in the FOMC minutes of the July 31 meeting, published on August 21, 2024; a full 3 weeks after the Fed statement. Incidentally, while the RBI publishes its MPC minutes 2 weeks after the policy statement, the Fed takes a week longer. The July 31 policy statement of the US Fed was quite explicit about the possibility of a rate cut in September. While the Fed continues to hold its stance that it would be looking at inflation showing a downward trend, the minutes indicate that there is sufficient consensus internally in the FOMC that the time was ripe to start cutting the rates. That was evident in the way the treasury yields fell after the minutes were announced. However, there are still voices of dissent internally in the FOMC. For instance, Michelle Bowman and Raphael Bostic have indicated in recent speeches that September may be too early to take a rate cut call and they would be more comfortable cutting rates towards the end of 2024.

What, possibly, tipped the scales in favour of the dovish club in the FOMC was the growth concerns as manifested in the July labour data. In fact, July 2024 saw the unemployment rate surge to 4.3%. Just about a year back, the rate of unemployment was at around 3.5%, a level that is described in the lexicon of economists as full employment. It was not just the unemployment rate that went up in July but even the jobless claims went up sharply. That had led to concerns that the so-called hard landing was finally setting in. In addition, the GDP growth had slowed sharply to just 1.4% in the first quarter of 2024, although it had bounced to 2.8% in the second quarter. However, the slowing industrial output does raise the spectre of an economic slowdown in the US. After managing to hold GDP growth in the positive through the rate hike period, the last thing the US wants in an election year is a perceptible slowdown in growth. Eventually, it is the fear of a slowdown in growth that could tip the scales in favour of a rate cut in September; rather than the fall in inflation.

CIRCA FED MINUTES (AUGUST 2024) – SEVEN KEY READINGS

The minutes of the June Fed meeting were published by the FOMC late on August 21, 2024. Here are our 6 key readings from the FOMC minutes and its implications for the future trajectory of interest rates.

• The view of majority of the participants was that “if data continued to come in as expected, it would be appropriate to ease policy at the next meeting.” However, it must be noted that the market has already fully priced in a rate cut in September. In fact, the CME Fedwatch has already assigned 100% probability to a 25 bps rate cut in September. The FOMC members used the word “more probably” for rate cuts in September.
• One view that appeared to be a consensus view was that the data must continue to be in conformity with a rate cut. That means a sharp spike in inflation or a spike in growth could even push the FOMC to rethink on rate cuts in September. That caveat is still there. Interestingly, several FOMC members had wanted the rate cut in July itself.
• There were 2 factors identified by the FOMC members for the proposed rate cut. Firstly, there had been substantial progress on inflation which was a positive trigger for rate cuts coming from consumer inflation and PCE inflation progressing persistently towards the 2% mark. On the other hand, the growth scare created by the labour data was another factor that has also made a case for rate cuts in September.
• When it comes to inflation, it is the outlook for inflation that actually matters a lot more. In this case, the FOMC members judged that recent data had increased their confidence that inflation was moving sustainably toward 2%. Members also observed that the factors that had contributed to recent disinflation would sustain the downward pressure on inflation in the coming months also.”
• The members of the FOMC admitted that there was a dilemma of sorts building up on the inflation front. For instance, the risks to the inflation goal had increased while the risks to the employment goal had gone up sharply. The good thing is that both these issues can be addressed with the same medicine; which is a rate cut. In a sense, that shows the sense of urgency that the FOMC members see in executing a rate cut.
• For now, the members of the Fed have not spoken about any long term trajectory for rates, as that would be clear only after the Fed embarks on its rate cuts, possibly in September 2024. The CME Fedwatch continues to be very positive on rate cuts and it is factoring in 3-4 rate cuts in 2024. In fact, if you take a longer term perspective, CME Fedwatch is looking at 7-8 rate cuts by end of 2025. However, the FOMC members are unwilling to even debate over such a long term view, till the first action is taken on rates.
• The only area of concern for the FOMC is that while the picture on inflation fall appears to be a genuine case of disinflation, the same cannot be said about the labour data. For instance, the labour data panic was short-lived as subsequent data releases showed jobless claims drifting back down to normal historical levels. In fact, even the retail sales data was better than expected. While, that assuages growth fears, it raises questions on whether there was room for more than one rate cut for now.

At the end of the day, the proof of the pudding lies in the eating. We have to wait and watch if the Fed cuts rates in September and the outlook it gives. In the past, the experience has been that when the CME Fedwatch oversteps the Fed outlook, it is the CME Fedwatch that falls in line eventually.

FED MINUTES AND THE IMPACT ON CME FEDWATCH

The table below captures the rate cut probabilities over the next 10 Fed meetings, based on the implied probabilities in the Fed futures trading; post the Fed minutes publication.

Fed Meet	250-275	275-300	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525
Sep-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	34.5%	65.5%
Nov-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	15.5%	48.4%	36.0%	Nil
Dec-24	Nil	Nil	Nil	Nil	Nil	5.6%	27.4%	44.0%	23.1%	Nil	Nil
Jan-25	Nil	Nil	Nil	0.5%	7.6%	28.9%	42.1%	21.0%	Nil	Nil	Nil
Mar-25	Nil	0.1%	1.4%	10.1%	30.5%	39.6%	18.5%	Nil	Nil	Nil	Nil
Apr-25	Nil	0.8%	6.2%	21.3%	35.5%	28.0%	8.3%	Nil	Nil	Nil	Nil
Jun-25	0.6%	5.0%	17.9%	32.3%	29.6%	12.7%	1.9%	Nil	Nil	Nil	Nil
Jul-25	2.7%	10.3%	23.9%	31.2%	22.6%	8.2%	1.1%	Nil	Nil	Nil	Nil
Sep-25	10.4%	20.5%	29.4%	24.8%	11.8%	2.9%	0.3%	Nil	Nil	Nil	Nil

Data source: CME Fedwatch

If you look at the probabilities compared to the previous minutes, there is substantial change. The CME Fedwatch is pencilling in very aggressive rate cuts by the Fed between September 2024 and September 2025, something that in no in sync with the indications given out by the Fed. Here is what the CME Fedwatch expects at 3 key milestone points.

• The CME Fedwatch has already assigned a 100% probability to the first rate cut happening in September 2024. However, there is more to it. The CME Fedwatch is assigning a 100% probability to 50 bps rate cut by November and a certain 75 bps rate cut by December 2024. In fact, there is a 77% probability assigned that the fourth rate cut of 25 bps may also happen by December 2024 itself. That is quite aggressive.
• In addition, the CME Fedwatch expects this aggression to continue into the next year also. By the second milestone of April 2025, the CME Fedwatch has assigned a 91.7% probability that the Fed would have cut rates by 125 bps and a 72% probability that the Fed would have cut rates by a full 150 basis points. Let us now turn to the final milestone point.
• As of September 2025, the CME Fedwatch is assigning a 97% probability to 175 bps of rate cuts and a probability of 85.5% to a 200 bps rate cut. In short, the CME Fedwatch is assigning a very high probability of over 85% to the possibility that the Fed would cut rates by a full 200 basis points to a level of 3.25%-3.50%. That is a lot more aggressive than the most optimistic estimates of the Fed.

It is hard to fathom what could be the justification for the CME Fedwatch to get so aggressively dovish. Falling inflation alone cannot justify such sharp rate cuts, so apparently the CME Fedwatch expects weak growth to accompany low inflation. That is the only economic crisis situation that could even remotely justify such aggression in rate cuts.

BETWEEN THE LINES OF THE AUGUST 2024 FED MINUTES

The FOMC minutes of the June meeting, published on August 21, 2024, showed the first signs of a likely rate cut. Here is what we read between the lines.

• The minutes of July meeting, released on August 21, 2024 showed that “vast majority” of officials felt that a rate cut was very likely in September. In fact, some policymakers had even wanted to pre-empt the market by cutting rates in July, in order to reduce the borrowing costs. That has raised the probability of a rate cut in September substantially.
• There is apparently a dichotomy of views that is quite strident within the FOMC members. For instance, many Fed officials viewed the stance of rates to be too restrictive. Other members were more measured and contended that amid cooling in inflationary pressures, status quo on rates would could increase drag on GDP growth.
• Experts believe that the August Fed minutes had almost removed any doubts about a September rate cut. Traditionally, the Fed’s communication strategy is to make its meetings less of a market-moving event. The cautious stance of the FOMC members must be seen from that perspective. Experts feel that the central bank is clearly data driven, and the current data was literally screaming for a rate cut.
• Clearly, the dual impact of low inflation and disconcerting labour data may impel the Fed to move faster on rate cuts. While the Fed has to still take a call on whether inflation was progressing towards 2%, what cannot be disputed are two hard realities. The first reality is that the labour and consumption data shows a lot of economic uncertainty. Secondly, the high cost of funds due to steadily high rates, was starting to hit business.
• In the current week, the markets for now, will await another trigger. Jerome Powell is scheduled to speak at the Jackson Hole Symposium later this week and his speech will be closely watched for indications of a possible rate cut. In addition, the markets will also track the speech of Kazuo Ueda, governor of the Bank of Japan, which is the only large central bank to have recently turned hawkish.
• There are still some key data points between now and the September Fed meeting scheduled to make its statement on September 18, 2024. There is the PCE inflation for July expected in the last week of August, the Q2 GDP updated, the August employment data in the first week of September and the US consumer inflation in the second week of September. All these data points would, hopefully, make a case for a rate cut in Sep-24.

For now, the Fed has given its first official hint that the first rate cut could happen in September 2024. However, the big question is; what happens after that. Fed is ambivalent and the CME Fedwatch is super-aggressive on the dovish side. The truth, probably, lies somewhere in between.

HOW WILL RBI INTERPRET AUGUST FOMC MINUTES

The RBI had implemented its last rate hike in February 2023 and has since held rates static for the next 9 meetings; including the August 2024 MPC (Monetary Policy Committee) meeting. There are two sides to the story that is emerging now. Firstly, food inflation continues to be high, and the latest inflation reading of 3.54% for July 2024 should be seen more as an exception than a rule. The base effect can be deceptive and once the base effect normalizes, food inflation would continue to be high. On the other hand, although growth is still robust, one can see the impact on the rising cost of funds of corporates. In Q2FY25, corporate India reported higher operating margins (OPM), but net profits fell by 4% due to higher interest costs. This is something that the RBI is conscious of and it would not want the situation to deteriorate beyond a point.

For now, the RBI would be on wait-and-watch mode till the US actually cuts the repo rates in September. The RBI has the luxury of a few more data points on consumer inflation, IIP, and core sector; which will provide the perfect backdrop for the RBI to take a data-driven call on interest rates. There are also fundamental compulsions for the RBI to cut rates. The real interest continues to hover around 2% while the current repo rates are a full 135 bps above the pre-COVID levels. With growth normalizing and much higher than pre-COVID levels, it is time the RBI also started to turn dovish. One can expect the story to unravel in October 2024.