Against all odds, more than 500 basis points in rate hikes from the Federal Reserve since March 2022 didn’t break the US economy. And at this week’s meeting, the central bank will be able to make the case that beginning to lower rates soon will help preserve a highly unusual economic expansion, one that started with mobility restrictions, Zoom meetings, and “stimmys,” and is now defined by record air travel, a multi-year Eras Tour, and an uncertain AI boom.
Most economists expect some hints that rate cuts are imminent in the central bank’s statement on Wednesday, or during Federal Reserve Chair Jerome Powell’s press conference.
What’s allowing the US central bank to soon begin breathing some life back into economic activity?
Well, for starters, inflation has decelerated a lot.
Omair Sharif, the founder of Inflation Insights, flagged in a note to clients that “we’ve now had 10 of the last 13 core PCE readings average 0.168%, or 2.0% annualized.”
Surely, 10 good prints handedly outweigh 3 bad ones.
Add to this encouraging trend that any labor-centric, income-driven component to inflation has disappeared. The growth in labor income received by Americans is within a hair of the 2014-2019 average — a time during which Fed officials bemoaned how slowly prices were rising.
The grind higher in the unemployment rate, from a low of 3.4% to 4.1% as of June, cannot be simply waved away in the context of this slowing trend in total labor income — even if this is tied to a positive supply story in the form of higher immigration. Lower income growth equals slower growth in consumer spending. On a seemingly related note, companies in the consumer discretionary sector have exceeded earnings expectations by less than any other so far this earnings season. Firms that focus on restoring their value proposition (i.e. keeping a lid on prices) are being rewarded by investors.
One way to think about rate cuts is that the Federal Reserve makes companies/people spend more on interest payments so they have less money to spend hiring workers/buying things. Lowering interest rates is a signal that interest expenses should go down to protect labor income growth from going down.
And while second-quarter GDP growth came in above expectations, private sector demand growth has been nothing special for years now. There’s no reason to suspect that the economy will receive any incremental fiscal boost until next year — if that, depending on the outcome of the election.
Growth, inflation, and the labor market are all sending the same message — it’s about time to be cutting interest rates. Based on the Federal Reserve’s September 2023 forecasts, policy rates should be lower given the current levels of core PCE inflation and the unemployment rate.
Strategists have coalesced around the “when” for the start of Fed rate cuts (September). Now, the conversation is shifting to “how much?”
That’s right. Before the easing cycle even starts, we need to think about how and why it’ll end.
Since Powell’s crystal ball is as foggy as the rest of ours, data squarely related to the central bank’s dual mandate goals (maximum employment and price stability) will loom large.
“When they start to see the labor market re-tightening, the unemployment rate stabilizing or perhaps moving lower, that would be an important tell,” said Evan Brown, portfolio manager and head of multi-asset strategy at UBS Asset Management (disclosure: Brown is my former boss!). “They also need to see how inflation is coming in — if core PCE is 2 to 2.5%, they may be able to keep cutting a little more, but in the high 2s or above that, you could see them stop rather abruptly.”
Back in January, the low point on the Secured Overnight Financing Rate futures curve (which largely tracks the Fed’s policy rate) was about 3.1%.
Now, there’s more evidence that the labor market has softened (while, admittedly, growth has been stronger than start-of-year forecasts anticipated), and the low point on the SOFR curve is 30 basis points higher.
One element behind this is that perceived recession risk — a condition under which the Federal Reserve would cut a lot more than the modal expected scenario — has decreased. But it’s a little bit curious that this has happened during a period in which interest-rate sensitive parts of the economy have shown little signs of a boost from the decline in bond yields since October 2023.
The hamstrung housing market stands out. There’s been only a meager upswing in mortgage applications despite a 100 basis point drop in mortgage rates.
New and existing home sales are moribund, and the pipeline of new one-family homes that were sold before they were even started has dwindled. That raises the risk that employment in the sector may come under pressure without help from lower rates.
“That’s the escape valve for how much they do — I think there’s something to the idea that the Fed keeps cutting until the housing market and other credit-sensitive parts of the economy turn higher,” said Neil Dutta, head of US economics at Renaissance Macro Research.
Even if rate cuts are telegraphed and well-embedded in financial markets, some key positive economic impacts won’t happen until the US central bank actually follows through.
“Small business loans, auto loans, those aren’t priced off the Treasury strip, they’re priced off of the Fed’s policy rate,” he added.
There’s another way that rate cuts may help support housing activity, which is more linked to longer-term yields than the Fed’s main rate. There’s $6.1 trillion in money market funds that faces reinvestment risk as policy rates — and returns on cash — go down.
The federal funds rate has been higher than the 10-year Treasury yield for more than 20 months. The more policy rates fall, or are expected to fall, the more attractive it will become to hold longer-term interest bearing assets, pushing their prices higher and yields lower. Even regional banks, which were burned by how high bond yields rose, are willing to extend duration once again.
The lack of responsiveness from rate-sensitive parts of the economy to the move lower in yields has been a modest concern as of late, but may also end up being a silver lining. Perhaps it’s just a matter of time (and rate cuts) before they do.
“Ultimately, the Fed will cut some, but it need not fully realize market pricing to keep risk assets happy, just starting easing and noting that lower inflation means the labor market put is closer to in-the-money (i.e. the Fed has the economy’s back) helps,” said Peter Williams, economist at 22V Research. "There's nothing wrong with this economy that lower rates for a while, if they're really needed, can't fix."
