Fed goes for the jugular, cuts rates by whopping 50 bps

19 Sep 2024 , 12:22 PM

FED CUTS RATES BY 50 BPS TO 4.75%-5.00% IN SEPTEMBER

That the Fed would cut rates on September 18, 2024 was, perhaps, the worst kept secret. The only question was whether the Fed would cut the rates by 25 bps or 50 bps. Contrary to the general belief, the Fed went ahead and cut rates by 50 bps. Now the rates are settled in a range of 4.75%-5.00%. As if that was not enough, the Fed has also indicated that there would be two more cuts of 25 bps each by the end of this year. The first hints had already come when Powell had delivered his speech at Jackson Hole. It got reinforced when Chris Waller mentioned that Fed must not delay front-loading rate cuts. He did not want a repeat of the way the Fed had delayed front loading rate hikes in late 2021.

In a sense, the rate cuts are quite small in the context of the rate hikes. Between March 2022 and July 2023, the Fed had undertaken 11 rate hikes taking the rates from a level of 0.00%-0.25% to a peak level of 5.25%-5.50%. The idea then was to contain inflation. FOMC members like Waller had pointed out that the Fed should have commenced rate hikes in October 2021 when inflation was starting to rise, rather than waiting till March 2022. That allowed inflation to become endemic. There is no point being a prophet of the past. However, while a 25 bps rate cut was acceptable to all members, only 11 out of the 19 FOMC members voted for a 50 bps rate cut. A committed hawk, Michelle Bowman, gave a dissent note for this decision to cut rates by 50 bps.

WHY WERE EQUITY MARKETS NOT IMPRESSED?

The big question that arises is; if aggressive rate cuts was what the markets wanted, why were indices not impressed? The Dow surged after the policy announcement but fell sharply towards the end of the day. To understand the market reaction, there are two key macro signals to look at. Firstly, there is the inflation data. The consumer inflation for August 2024 came in sharply lower at 2.5%. However, this was on the back of falling energy inflation, even as core inflation has gone up by 30 bps in the last 2 months. But the bigger area of concern is the jobs data. The level of unemployment was at 4.3% in July and at 4.2% in August 2024. However, in absolute terms the number of people unemployed remains the same. That is a clear indication that the US economy is vulnerable to a hard landing. Remember, hard landing is when persistently high rates impact growth. That had been avoided for a long time. Now, the jobs data and the inversion of the yield curve points to the contrary. The markets are concerned that the Fed cutting rates by 50 bps is tacit admission of risks to US economic growth.

KEY SIGNALS FROM THE SEPTEMBER 2024 FED STATEMENT

The Federal Open Market Committee (FOMC) lowered its key overnight borrowing rate by a 50 basis points, amid clear signals that inflation was moderating and labour market was weakening. It was the first rate cut since the start of the pandemic. The 50 bps rate cut indicates that the FOMC now has greater confidence that inflation is moving sustainably towards 2% and the risks to its employment and inflation goals are roughly in balance Here are key takeaways from the Fed Statement on September 18, 2024.

• The rate cut of 50 bps was intended to head off a slowdown in the labour market, but was also a tacit admission that all was not hunky dory with the US economy. Interestingly, this kind of a message is coming just 7 weeks ahead of the US going to its presidential polls. The rate cut was twice what Powell had indicated at Jackson Hole.
• The size of the first rate cut is quite interesting. The last time the Fed had cut the rates on an emergency basis by 50 bps was during the global financial crisis in 2008. The decision brings down the Fed rate to the range of 4.75%-5.00%; but also raises questions on whether the message sent by the Fed was intentional or inadvertent.
• As if the 50 bps rate cut was not sufficient, a cursory look at the dot-plot chart of the members of the FOMC points to the equivalent of another 50 bps rate cut by the end of 2024. In addition, the dot-plot chart is also pencilling in another 100 bps rate cut in 2025 and another 50 bps by middle of 2026; making it 250 bps in total in next 21 months.
• As Powell stated in his post-policy conference, the FOMC has gained greater confidence that inflation is moving sustainably toward 2% and there is a balance of risk between the inflation and employment goals. While a number of FOMC members avoided the vote on an additional 25 bps rate cut, Michelle Bowman was the sole dissenting voice.
• The strategy was best explained by Jerome Powell, in his post-policy interaction. To quote Powell, “The Fed is trying to achieve a situation where we restore price stability without the kind of painful increase in unemployment that has come sometimes with this inflation. This 50 bps rate cut is the Fed commitment to that goal.”
• While the dot-plot chart hinted at another 50 bps rate cut this year, Powell refused to commit to any such action in his post policy. However, this refusal to commit must not be interpreted as another 50 bps being unlikely. The Fed is also committed to managing inflation expectations and Jerome Powell is just erring on the side of caution.
• FOMC projections for 2024 show that the rate of unemployment has been raised by 40 bps to 4.4% by the end of 2024. That is 20 bps higher than the August unemployment rate. However, inflation outlook has been lowered by 30 bps to 2.3% by end of 2024. This reinforces the fact that it will now be jobs over inflation; so, more rate cuts could be on the cards.
• The Fed approach is not surprising since the real problem is in the jobs data. While layoffs have shown little signs of rebounding, hiring has slowed significantly. In fact, the last time the monthly hiring rate was as low as 3.5% of the labour force. The last time the monthly hiring was so low, the unemployment rate was above 6%. If the FOMC is going to focus on jobs, then more aggressive rate cuts are on the cards.
• With the US being the fulcrum of the world economy, it will not be too long before other economies follow the dovish path. The US is shifting focus from inflation to jobs. While some central banks like the Bank of England, Bank of Canada, and the ECB have cut rates recently, they are likely to get more aggressive; even as other central banks join in.
• One final word on the quantitative tightening that had brought the Fed balance sheet bond holdings down from $9 Trillion to $7.2 Trillion. To magnify the impact of the rate cuts, the monthly roll-off has already been reduced from $95 Billion to $50 Billion. Clearly, that double thrust is likely to give a liquidity boost to the economy.

September FOMC meet is done and dusted and the Fed has cut rates by 50 bps and hinted at another 50 bps by end of 2024. For now, the Fed is moving exactly in sync with what the CME Fedwatch has been suggesting. That is quite a shift from the past; when the CME Fedwatch had to fall in line with the Fed thinking.

CME FEDWATCH LEADS THE WAY; FED SAYS OK

One way to look at the Fed outlook from a market perspective is to evaluate the CME Fedwatch; which captures the probabilities of rate moves at each upcoming Fed meet. This is based on implied probabilities of Fed Futures trading.

Fed Meet	200-225 #	225-250	250-275	275-300	300-325	325-350	350-375	375-400	400-425	425-450	450-475
Nov-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	30.2%	69.8%
Dec-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	14.7%	48.0%	37.3%	Nil
Jan-25	Nil	Nil	Nil	Nil	Nil	4.8%	25.6%	44.5%	25.2%	Nil	Nil
Mar-25	Nil	Nil	Nil	1.2%	10.2%	30.5%	39.5%	18.6%	Nil	Nil	Nil
May-25	Nil	Nil	1.1%	8.8%	27.4%	38.1%	21.8%	2.8%	Nil	Nil	Nil
Jun-25	Nil	0.7%	6.4%	21.5%	34.7%	27.0%	8.9%	0.9%	Nil	Nil	Nil
Jul-25	0.3%	2.7%	11.7%	26.1%	32.0%	20.6%	6.1%	0.6%	Nil	Nil	Nil
Sep-25	1.0%	5.0%	15.4%	27.6%	29.0%	16.8%	4.6%	0.4%	Nil	Nil	Nil
Oct-25	1.7%	6.6%	17.3%	27.8%	27.2%	15.0%	4.0%	0.4%	Nil	Nil	Nil
Dec-25	2.4%	7.8%	18.5%	27.8%	25.8%	13.7%	3.6%	0.3%	Nil	Nil	Nil

Data source: CME Fedwatch (# – lower probabilities consolidated)

The CME Fedwatch has been broken up into 3 milestones; December 2024, June 2025, and December 2025. The probabilities of rate cuts and the eventual rates at each of these milestone has been evaluated. Here are our quick inferences for next 16 months.

• With the September rate cut of 50 bps done, the focus now shifts to November and December FOMC meets. The CME Fedwatch assigned a probability of 100% to 25 bps rate cuts and 30.2% probability to another 50 bps rate cut by November 2024.
• Let us look at the first milestone of December 2024. By then, another 50 bps rate cut is considered certain. Also, there is a probability of 48.0% for an additional 75 bps rate cut. So, it could either be a total rate cut of 100 bps or 125 bps in all by end of year 2024.
• Probabilities beyond 2024 are still evolving and will offer more clarity once the current year action is visible. Let us look at June 2025. The CME Fedwatch is assigning 99.1% probability for 175 bps rate cuts from the peak and 90.2% chance for 200 bps rate cuts from the peak by June 2025.
• Let us come to the final milestone of December 2025. At this point, the CME Fedwatch is estimating 96.1% probability for 200 bps of rate cuts from the peak and a high probability of 87.5% for 225 bps of rate cuts by December 2025. There is a 56.6% probability that the Fed could close year 2025 having cut rates by a full 250 bps from peak and moved to (2.75%-3.00%).

For now, we have only seen the tip of the iceberg and as more data flows in and depending on the Fed action in November and December; these probabilities should get fine-tuned. One thing the CME Fedwatch can feel elated is that, this time they were bang on target.

FED THEME – INFLATION BATTLE WON; JOBS BATTLE COMMENCES

If one were to summarize the gist of the Fed policy statement issued on September 18, 2024, it would be, “Inflation battle won; jobs battle starts.” There is enough evidence to suggest that inflation has been substantially, if not entirely, brought under control. However, while it did not directly impact growth, it has impacted jobs by spiking the rate of unemployment. That will mark the strategy shift of Fed policy from here on. Here is how.

• Powell has referred to the latest move as a “recalibration” to account for the sharp fall in inflation since last year. Powell noted that, while economic growth remained strong, stress is evident in the weakening in the job market. The call for the Fed was whether it was worth trading more jobs to push inflation to 2% rapidly. The consensus was that the trade was not worth it; resulting in the shift from inflation to full employment.
• One of the presidential candidates, Donald Trump, has called the 50 bps rate cut frightening. According to Trump, the US economy may be in a lot more trouble than what the policy makers are making out to be. However, just 7 weeks ahead of the presidential elections, such statements may be more of politics and less of economics. One may have to take that with a pinch of salt.
• Experts highlight that there could be some dissonance in the data. The inflation currently stands at 2.5% and the projected level of inflation is 2.3% by end of 2024 and 2.1% by end of 2025. That is not in consonance with the latest policy shift which has decided not to trade more jobs for inflation control. Statistically, it is hard to see how the inflation could trend 40 bps lower by end of 2025, with the current macros.
• Finally, Powell summed up the situation best. “We’re not saying ‘Mission Accomplished on Inflation. We are just encouraged by the progress we have made. At the same time, the jobs growth has slowed and unemployment rate is at 4.2%. The concern now is that high interest rates could eventually prove to be an unnecessary drag on the economy.”

The macro data points between now and December 2024 and beyond, will still carry a lot of weight in how the Fed rate cuts evolve. For now, the Fed has signalled a shift. The question is; if it will serve the purpose.

RBI HAS TO MOVE; SOONER RATHER THAN LATER

RBI implemented its last rate hike in February 2023 and has kept status quo since then. However, the Fed decision to front-load rate cuts by 50 bps in September is likely to put the RBI under pressure. There are enough reasons for the RBI to also cut rates. The current repo rates in India are a full 135 bps above the pre-pandemic rates. Secondly, the real rates of interest are now well above 2%, much higher than the pre-pandemic median. Thirdly, the pressure of higher rates is evident in the corporate profitability; calling for some relief!

There are enough macro signals for the RBI to move quickly on rate cuts. The headline inflation has now been under the RBI target of 4% for 2 months in a row. Food inflation has come down sharply in recent months with a better than expected Kharif harvest. Energy inflation, which has high externalities, is also subdued with global Brent crude prices falling to $71/bbl levels. Core inflation may be hardening, but the supply chain issues are history, and hence the upside risks are quite low. However, it is important that the RBI crystallizes its point of view and communicates at the earliest!