The Over or Under on Rate Cuts
Telemus Weekly Market Review January 22nd, 2024 - January 26th, 2024
The U.S. economy remains resilient. This week, the Bureau of Economic Analysis reported that the U.S. economy grew 3.3%. The strength of the economy comes with unemployment at ultra-low levels and inflation dropping from an annualized rate of over 9% in June of 2022 to roughly 3% by the end of 2023.
This backdrop leaves an interesting proposition for the Federal Reserve, which meets this coming week. Expectations are for the Federal Reserve Open Market Committee (FOMC) to hold interest rates steady at this meeting. However, markets expectations are inferring that the Fed will begin to cut rates as early as its following meeting in March. In total, financial markets are implying as many as six cuts by the Fed before the end of 2024. This differs from the FOMC’s projections, which presently expect only three cuts. This dichotomy creates a challenging proposition for investors as they are forced to either take the under, with expectations closer to the Fed, or take the over, and side with market expectations that imply double the rate cuts that the Fed projects.
In assessing this dynamic, we begin by first examining how the Fed may apply economic data to its mandate of maintaining stable prices and seeking maximum employment. Nowhere in this mandate are they charged with maintaining a set rate of growth in the economy, although there is relationship between the health of the economy and their directive. At this point, employment isn’t a problem although expectations are for a gradual rise in the rate of unemployment. We’ve seen the number of job openings per unemployed fall, and we occasionally hear headlines around corporate restructurings that may temporarily add to the number of unemployment claims. At this point, unemployment isn’t an issue, and the labor market is strong. However, the open is question is what data might prompt the Fed to be more proactive in getting ahead of a change in this trend.
On the inflation front, conditions seem reasonable. True the current inflation rate of 3.4% is ahead of the Fed’s target of 2%, but food and gas prices seem to have stabilized, while shelter and used car prices have more recently shown signs they may be decelerating. While this is favorable for inflation, growth in wages remains elevated at over 4% and healthcare costs are on the rise with utilization rates accelerating.
Our view is that the FOMC does not need to be in a hurry to cut rates and could use some confirmation that prices around shelter and use cars are indeed moving lower. This should provide some confidence that there is a ceiling, for now, on inflation. Should that happen, it could open the door for some opportunistic rate cuts to proactively support the economy and labor market. In such a scenario, the key question will be whether the Fed does this in a slow and gradual manner, maintaining a data dependent stance. Alternatively, they could elect to identify a level of interest rates they are comfortable getting to quickly, and then pause to assess its impact.
In our view, the market is expecting the latter, believing the Fed will cut the interest rate metric it controls, the federal funds rate, from the current target range of 5.25% to 5.50% down 3.75% to 4.0% by the end of 2024. While this seems aggressive, and it very well may be, the Fed can stand behind this and say its still a restrictive interest rate policy given the Fed’s view that a long-term normalized federal funds rate should be 2.5%. If the Fed elects to go this route, they will need a high degree of confidence that inflation is in check and that a lower level of interest rates won’t reignite inflation. We see risk here as we believe higher rates have created pent up demand among higher priced durable goods such as housing and industrial equipment. A fed funds rate at around 4% will help to thaw some of this demand, although there is ambiguity in how significant that will be.
Alternatively, the Fed could elect to be more gradual and data contingent when cutting rates. The benefit of this route is it will give the Fed an opportunity to assess the impact before making added cuts. This does, however, come with the risk that unemployment could rise quicker than anticipated. The Fed would then be pushed to act quicker and more aggressively than they would prefer.
As we look to this week’s Fed meeting our attention will be not on when the Fed might cut but rather on its mindset around cutting interest rates. If they indicate a willingness to take a more aggressive stance down to a pre-set level, then interest rates embedded within the bond market appear reasonable. If they are more likely to be slow and gradual, there is a risk that yields on Treasury bonds may rise in the short-term. Since markets are regularly repricing expectations for what the Fed might do, it’s rhetoric and decision making is likely to remain a significant impact on financial markets throughout 2024.
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Matt joined the Telemus team in 2018. As Chief Investment Officer, he leads the firms the investment process and research effort. Matt has experience as an equity analyst and portfolio manager and has advised corporate pension plans on their manager selection. He’s been quoted in Money Magazine and Barron’s.