The financial markets have recently begun to price in a larger rate cut by the Federal Reserve. Approximately 110 basis points are expected to be cut by the end of the year. This isn’t surprising, given that Powell announced last month that the time for lower interest rates has come. In fact, he also mentioned that the first rate cut will occur mid-month, but he left unclear how large the cut will be and how quickly it will happen. According to him, this will depend on the future trajectory of the economy, wage growth, and inflation.
In this context, it’s understandable that the markets were eagerly anticipating last Friday’s employment data. If these figures indicated a rapid slowdown in the U.S. economy, the Fed could cut rates more than expected. Conversely, if the data showed continued strong growth, rates might start to rise again for a while.
This means we first need to define what constitutes strong or weak growth, which should be viewed against the following backdrop:
- The Fed is determined to avoid a recession at all costs. Given the high debt levels, a recession would be too dangerous. The Fed is unwilling to take that risk, especially now that inflation is approaching its 2% target.
- The challenge, however, is that changes in interest rates take several quarters to impact the economy. This implies that if a recession is expected by mid-2025, rate cuts need to start now.
- On the other hand, inflation must remain under control, and the economy should not exceed its potential growth rate, which is currently around 2.25% but is likely to drop slightly below 2% in the coming quarters.
Looking at the recent employment numbers and wage increases in this context, there’s little reason to believe that growth is falling below 2%. However, growth has been on a mild downward trend for some time. The Fed must be careful that this slowdown doesn’t suddenly accelerate, which could happen due to an external event or a sharp drop in stock or real estate prices for example.
Therefore, while the latest employment figures suggest that growth is around the desired 2%, it seems prudent to lower rates now as a precautionary measure. There’s another factor to consider: the upcoming elections. The outcome could lead to increased fiscal stimulus, driving inflation higher—or, conversely, the opposite could happen, or anything in between.
All in all we expect the Fed to proceed cautiously. It will likely cut rates by around 75 basis points this year. In the first half of 2025, another 75 basis points could be cut as insurance against a potential recession. Only if the data shows more weakness than the latest unemployment figures suggest could there be further rate cuts. However, there is currently no concrete evidence to anticipate this.
Comparing this with what the markets have recently priced in, we believe there will be slightly more growth and somewhat fewer rate cuts by the Fed than expected. This could be mildly positive for stocks in the short term and slightly negative for bonds. Finally, the dollar may rise against the euro, as the data from Europe points to very low growth and increasing political uncertainty. The ECB may cut rates more than expected in response. For the ones interested, more specific expectations can be requested by sending an email to [email protected].
