Fed Speak – What is the rush to cut interest rates?

28 Feb 2024 , 11:17 AM

MARKETS ARE EXPECTING RATE CUTS, BUT LESS AGGRESSIVE

In the last few weeks, there was a tense stand-off between the US Fed and the financial markets that trades Fed futures, represented by the CME Fedwatch. In the end, as is normally the case, the Fed had the last laugh, but first a quick background. In the December monetary policy, the Fed had announced that it would cut the benchmark rates thrice in 2024 and another 4 times in 2025. Since the cuts are normally for 25 bps each, the general expectation was that the Fed would cut rates by 175 bps by the end of 2025. However, the CME Fedwatch turned a lot more aggressive and pegged that the Fed would cut rates by 175 bps in the year 2024 itself. However, some moderation appears to have sunk in the last few weeks with the Fed sticking to its stand of refusing to give a time table on rate cuts. Additionally, the higher inflation reading also narrowed the gap and by the latest policy announcement, the Fed and the CME Fedwatch were almost in sync, as you can see from the table below.

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Mar-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	4.0%	96.0%
May-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	0.9%	25.3%	73.8%
Jun-24	Nil	Nil	Nil	Nil	Nil	Nil	0.5%	14.3%	52.0%	33.1%
Jul-24	Nil	Nil	Nil	Nil	Nil	0.3%	8.2%	35.4%	41.5%	14.7%
Sep-24	Nil	Nil	Nil	Nil	0.2%	5.7%	26.7%	39.5%	23.2%	4.7%
Nov-24	Nil	Nil	Nil	0.1%	2.9%	16.2%	33.1%	31.4%	14.0%	2.3%
Dec-24	Nil	Nil	0.1%	2.0%	11.7%	27.4%	32.0%	19.8%	6.2%	0.8%
Jan-25	Nil	Nil	1.2%	7.6%	20.8%	30.0%	25.0%	12.0%	3.1%	0.3%
Mar-25	Nil	0.5%	3.6%	12.5%	24.2%	28.1%	20.1%	8.7%	2.1%	0.2%
Apr-25	0.3%	2.4%	9.2%	19.9%	26.7%	23.1%	13.0%	4.5%	0.9%	0.1%

Data Source: CME Fedwatch

As the above data depicts, now even the CME Fedwatch is pegging the rates to fall by around 75 bps by the end of 2024 and by about 100-125 bps by June 2025. But that is not the point. The real issue was raised by Fed governor Christopher Waller, who asked the fundamental question, “What is the big rush to cut repo rates.”

WHAT IS THE BIG RUSH TO CUT RATES?

There are several reasons why Christopher Waller believes that the Fed can afford to wait on rate cuts and actually should go slow on rate cuts. 

1. Let us talk about the GDP growth first. Till now, the US Bureau of Economic Analysis (BEA) has put out the data on first advance estimates for Q4 GDP at 3.3%. The second estimate is expected on February 28, 2024 with the final estimate towards the end of March 2024. However, the fourth quarter GDP is expected to be above 3%, which means the full year GDP for 2023 for the US economy should be above 2.2%. In addition, even the GDP estimates of the Atlanta Fed for Q1-2024 indicate that the robustness in GDP should continue in 2024 also. The point that Waller is making is that, when the economic growth is robust, there is little reason for the Fed to upset the applecart by cutting rates.

    

2. The second that has triggered this question on “what is the hurry to cut rates” emerges from the employment data. As per the latest report, the jobs grew by 353,000, well above the forecasts of less sub-200,000 levels as was being expected. Also, the rate of unemployment stays at 3.7%. This may not be as low as the recent levels of 3.4%, but it is still sharply lower than any of the economic growth periods in the past. This again underlines the need to hold on to status quo on rates. After all, aggressive rate cuts at this juncture could only make the labour market tighter and worsen inflation problem.

    

3. Finally, we come to the inflation story. The PCE inflation for January is expected on the last day of February, but the January consumer inflation at 3.1% was higher than expected. Of course, CPI inflation was lower than the 3.4% reported in December 2023, but then it is 20 bps above the expected level of 2.9%. Clearly, with inflation at elevated, the incentive to cut rates immediately is not there.

The gist of the story, as presented by Christopher Waller is that there is no tearing hurry to be cutting rates. Eventually rate cuts will happen, but they can be gradual and calibrated.

WHAT DOES THIS MEAN FOR THE FED MONETARY POLICY?

That brings us to the million dollar question. If GDP is robust enough; if labour market is to tight and if inflation is not as low as it should be, then what does that mean for the monetary policy in the US? Here are some likely implications of the thought process.

• One thing is certain from the above data; the risk of hard landing or an inflation-induced recession for the time being is almost nil. It also means that there is enough evidence of ongoing robust growth in output and employment, although there are some scattered signals that growth may be slowing since the fourth quarter of 2023. However, it is certain that the US economy is healthy and poised to continue growing at a steady pace and also adding jobs more than the street estimates. The idea would be therefore to ensure that the economic fundamentals grow in a manner that is consistent with inflation at 2%. That makes a case to proceed carefully on easing monetary policy.

   

• The second big takeaway from the speech delivered by Christopher Waller is that while the decision to cut rates may have been taken, the timing and the pace of rate cuts are not yet finalized. In fact, the decision is an expression of intent and not a statement of execution. The actual rate cuts will only happen based on the incoming data on growth, inflation, and jobs additions. Hence, markets must not take the Fed indicated time frames of 3 rate cuts in 2024 and 4 rate cuts in 2025, as cast on stone. The rate cuts will happen, but subject to the data being supportive.

   

• In the last few months, the Fed has been criticized that it had been delaying the start of rate cuts, just as it had delayed the start of rate hikes. In fact, the rate hikes should have been started in the last quarter of 2021, instead of March 2022. However, the Fed is in the thick of action and they cannot be prophets of the past, or drive by looking at the rearview mirror. They have to be forward looking. Hence the argument that delaying rate cuts may keep policy rates overtight, is not warranted. According to Waller, most analysts and economists tend to be patient with rates on the way up, but somehow appear to be in a hurry on the way down. That is obviously an asymmetry in expectations. There is no evidence to suggest that delaying rate cuts could put the economy at a huge of recession. There is little evidence to back such claims.

   

• Lastly, Waller has underlined that in any rate cut program, it is the last mile that is normally the toughest. For instance, the PCE inflation may have just about 60-70 bps to travers to touch the 2% mark. However, that will not be a linear journey and will be in the midst of a lot of volatility. Waller has also added that rate cuts in the US (at least aggressive rate cuts) have only happened in the aftermath of huge recessions or a massive economic or financial crisis. This time around, we are far from any crisis since the GDP and the labour data suggest that the US economy is in fine fettle. That makes the job tougher for the Fed.

To sum up on Waller’s comments, the Fed is going to have a tough time deciding on the timing of rate cuts. However, the hawks within the system are of the view that the Fed should delay rate cuts since the current economic situation offers them that luxury. But the real story here is not about growth or inflation or labour market, but about the inherent risks in the current market. In the final section, we look at the key long term and short term risks for the US market, as outlined by governor Lisa Cook of the US Federal Reserve.

WHAT GOVERNOR LISA COOK HAS TO SAY ABOUT CURRENT RISK LEVELS

In a sense, the speech made by governor Lisa Cook is an extension of the lectured delivered by Christopher Waller. Here governor Lisa Cooks identifies the sources of the current macroeconomic uncertainty in the short run and also in the long run. The key uncertainty factors identified by Lisa Cook, is an extension of the question raised by Christopher Waller, about whether there is a real hurry to cut rates. There are two key uncertainties that have to be addressed at this juncture. Firstly, would supply remain persistently depressed because of scarring from the pandemic? Secondly, would inflation become stuck well above the Fed’s 2% target or even continue to rise? Obviously, there are no easy answers, but we can look at the current uncertainty in the short term and in the long term.

SHORT TERM UNCERTAINTY ON INFLATION AND SUPPLY CHAINS

Let us talk about the short term inflation uncertainty first. While the inflation has fallen from the peaks levels of over 7%, the last mile disinflation is already proving to be the hardest. The risk is that the disinflationary process may continue to be bumpy and uneven. Inflation in core services ex-housing has slowed, but the fall in services inflation is much slower than the fall in goods inflation and that continues to be a challenge. One good thing is that the people at large are convinced that the Fed will leave no stone unturned to contain inflation, and that has led to lowering of inflation expectations. 

What about the supply chain uncertainty? A strong supply-side recovery has contributed majorly to the recent disinflation. Global supply chains have largely recovered, and even in the absence of China, alternatives have emerged quite rapidly. There is a shift in demand away from goods and towards services, although that is not helping inflation much, only addressing the supply chain issues. One reason for the supply chains getting restored to the pre-pandemic levels is that even labour supply has recovered strongly. A rebound in immigration from the lows of the pandemic period, has been a key factor in putting supply chains back in shape. 

LONG TERM UNCERTAINTY ON SUPPLY CHAINS AND PRODUCTIVITY

Let us now turn to the long term sources of uncertainty. According to Lisa Cook, the post pandemic period is likely to be marked by perpetual supply chain constraints. This can take the form of Russia’s war on Ukraine or the ongoing turmoil in the Middle East, which have done long term damage to global supply chains. Then there are more structural challenges in the long term. For example, low water levels related to drought and high heat have disrupted shipping along key routes such as the Panama Canal and the Rhine River. One direct outcome of these long term risks is de-globalization or friend-shoring as it is now being called. That is dividing the world into less productive trade blocs.

The second impact is on long run productivity of industry. A lot of the post pandemic surge has come from productivity gains. Lisa Cook has pointed that many of these productivity gains may not really be sustainable. As labour markets normalize, even productivity is likely to normalize. On the other hand, the pace of adoption of artificial intelligence (AI) could also be a source of long term uncertainty in the markets. 

The moral of the story is that there is still a lot of uncertainty in the markets; both at the short end and at the long end. Also, with growth better than expected and inflation not yet full in control, it only brings us back to core issue, “What is the rush to cut rates now?”