Although a strong economy has changed expectations about the timing and magnitude of interest rate cuts, we still see room for the Federal Reserve to cut by three-quarters of a point this year.
In the past few months, expectations about the timing and magnitude of interest rate cuts by the Federal Reserve have changed dramatically. Earlier in the year, the federal funds futures market had priced in as many as six 25-basis-point1 cuts to the federal funds target rate, suggesting that the upper bound of the rate would fall from 5.5% to 4.25% this year.
Now that number is down to three, implying a year-end federal funds rate of 4.75%. Some are even suggesting that the Fed won't lower interest rates this year at all, due to the strength of the economy and the risk that inflation will remain too high.
One reason for the volatility in expectations is that the Fed has pushed back on the prospect for a rapid pace of rate cuts. Rather, it has indicated that it is "data dependent," watching every data point to assess the next policy move. That leaves investors to react to every economic indicator and extrapolate the results into the future. However, taking a long-term perspective, we still see room for the Fed to cut rates three times for a cumulative total of 75 basis points in 2024.
Inflation is trending lower
Various indicators point to lower inflation over the long run. The indicator that the Fed uses for setting policy, the deflator for personal consumption expenditures excluding food and energy (core PCE) is nearing the Fed's 2% target level and trending lower. The recent increase was driven to a large extent by rising fees for financial services, an outgrowth of the bull market in stocks leading to increased trading fees. While the bull market can continue, we doubt large monthly increases in fees are likely to be sustained going forward.
Meanwhile, prices at the wholesale level show little sign of inflation pressures. Producer Price Index (PPI) readings for both goods and services remain low.
Economic growth with productivity is not inflationary
An additional concern is that economic growth has been more resilient than expected in the face of Fed rate hikes. Inflation-adjusted, or "real," gross domestic product growth has averaged more than 4% over the past two quarters, the strongest pace since the rebound from the pandemic-led decline. Moreover, recession fears have abated. There are fears that stronger economic growth could lead to a rebound in inflation pressures. However, there has been a surge in productivity growth behind those numbers, which is not inflationary because it indicates that workers are generating more output per hour.
Fed policy is tight enough
By most measures, the Fed's policy interest rate is high enough to keep inflation in check. The real federal funds rate (fed funds adjusted for inflation) is the highest it has been since 2007. While the economy has managed to do well despite rate hikes, the real rate would rise if inflation continued to edge lower. There is little reason for the Fed to keep rates high as long as inflation pressures are subdued.
Moreover, looking at the various policy rules that the Fed takes into consideration, the current setting of the fed funds rate is high. A useful gauge is the "Taylor Rule," which estimates a target federal funds rate based on inflation and economic data, such as the output gap. It has been modified over the years. As the chart shows, the current fed funds rate is above the levels indicated by the various Taylor rules, which opens the door to the potential for rate cuts of 75 to as much as 200 basis points over the next year.
Volatility and opportunity
The sudden shifts in market expectations about the direction of interest rates can be unsettling. However, through the volatility, potential opportunities have emerged. We continue to believe that high quality, intermediate-term bonds offer attractive yields relative to the risk. Investors with a long-term time horizon should consider allocating to core bonds (Treasuries, other government-backed bonds, and investment-grade corporate bonds) at current yields of roughly 4.5% to 5.5%.2 The Fed may be hesitating to cut rates, but we continue to see room for yields to fall.
1 A basis point is a unit of measure for interest rates and other percentages in finance. One basis point is equal to one one-hundredth of 1%, or 0.01%.
2 Source: Based on the yields for the Bloomberg US Aggregate Bond Index and the Bloomberg US Corporate
Bond Index as of 3/6/2024.
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