Will the Fed backtrack on expectations for rate cuts?
time Fed meets this week Monetary policy will be faced with two forces pulling in opposite directions. Expectations that the Fed will cut interest rates It’s happened no less than five times this year, and the evidence continues to mount. Demand from the household sector is increasing.
Fed officials will need to decide whether and how strongly to reverse market expectations for rate cuts. We’ve heard some hints of a rebound from Fed officials, including: Governor Chris Waller and Atlanta Fed President Rafael Bostic But nothing is strong enough to make investors seriously reconsider their belief that the federal funds rate will fall somewhere between 3.75% and 4.25% by December.
When Fed officials met in December, Economic forecast overview (SEP)’s median forecast is for the federal funds rate to fall to 4.6% by the end of 2024, resulting in a target range of 4.5% to 4.75%. Therefore, the market is now pricing in at least two more rate cuts than the Fed expected. Federal funds futures currently suggest there is only a 3% chance that the federal funds rate at the end of the year will be as high as Fed officials’ median view, and no chance of it exceeding that.
Markets have backed off from expectations that the Fed will cut interest rates in March. At one point, this was priced in as almost a certainty.Now it looks like this 50/50 betaccording to odds implied by federal funds futures prices.
There is almost universal agreement The Fed is not expected to cut interest rates at its meeting this week. This is a change from late December, when the market seriously thought the Fed would start cutting rates soon, giving a 1 in 5 chance of a January rate cut.
What real interest rates tell us
The main driver of expectations that the Fed will cut rates significantly this year is that the inflation-adjusted The “real” federal funds rate is high By recent historical standards. According to , the real federal funds rate last month was 2.9%. Joe LaVogna, Chief US Economist at SMBC Nikko Securities. Lavorgna points out that this is the highest amount since August 2007. (To arrive at the real interest rate, Professor Lavorgna subtracted the 12-month personal consumption expenditures price index increase (2.8% in December) from the 5.5% ceiling on the nominal federal funds rate.)
This high real interest rate has come as a surprise to many, as inflation has fallen rapidly over the past year. overly restrictive. Furthermore, given that inflation continues to fall over the coming months, real interest rates will mechanically rise even if the Fed does nothing at all to its interest rate target. If PCE inflation were to fall to 2.2% (which is where the Cleveland Fed’s Inflation Nowcast currently projects January’s inflation rate), real interest rates would rise to 3.2%.
From left to right: Federal Reserve Board members Philip Jefferson, Christopher Waller, Lael Brainard, and Jerome Powell attend a Fed Listens event in Washington, DC, September 23, 2022. , Michael Barr, Michelle Bowman, and Lisa Cook. (Al Drago/Bloomberg via Getty Images)
As Lavorgna points out, the Fed has said it is targeting 2% inflation, and the long-term trend of the federal funds rate is at the midpoint of 2.75%. In other words, The Fed targets real interest rates of 0.75%. Clearly, a real interest rate of 3.2% is far above what the Fed considers normal and healthy.
It’s worth noting, however, that the Fed’s projections through the end of this year have a median expected real interest rate of around 2.35 (I’m using the upper end of the target range here for consistency) . The expected real interest rate in 2025 falls to 1.65%. And in 2026, it will fall to 1%. Therefore, the Fed’s view is that real interest rates should, and probably will, be: Improved in line with historical standards for years to come.
In other words, Inflation rate needs to fall to 1.65% This is to justify cutting the Fed rate to 4% if the Fed does not change its implicit real interest rate target. For inflation to be this low by the end of the year requires a very dovish view of inflation.
Of course, if inflation declines rapidly, the Fed could, and likely will, adjust downward its view of the appropriate real interest rate. So, Views suggested by financial markets It’s not impossible today, but it will require a lot of changes this year.
Fed Chairman Jerome Powell’s press conference will be an opportunity for the Fed to tell market participants whether it is a prudent position. Will the Fed stick to the position it secured in December or Follow the views of fixed income traders?
