Predicting the Fed’s Interest Rate Cuts

The Federal Reserve is closely monitoring economic data to determine the appropriate time to lower the target for the federal fund benchmark interest rate. Despite indicators showing that the economy didn’t slow down as much as expected in the fourth quarter of 2023, with consumer spending on the rise and a resilient labor market, there is a persistent market belief that a rate cut is imminent, likely at the second or third meeting of the Federal Open Market Committee (FOMC) this year.

Market Expectations vs. Economic Reality

As of January 18, 2024, market sentiment leaned towards a rate cut announcement at the first meeting in March, with a probability of 55%, as indicated by the CME Group’s FedWatch tool. This probability has decreased from the 75% implied by swaps prices a week ago but remains relatively high given the current economic conditions. The consensus in the market is that there is a better-than-90% chance of a rate cut at the May meeting, with debates focusing on whether it will be the first or second cut. Some investors may also be considering the possibility of a March cut followed by a pause in May.

The Unlikely Scenario: No Rate Cuts by June

However, the market seems to dismiss the possibility that the Fed will not have made any rate cuts by the June meeting, just five months from now. There is virtually no credibility on Wall Street for the idea that rates will remain unchanged. The implied odds of rates staying at their current levels are close to zero. The market predicts a 7% chance of rates being 25 basis points lower, a 42% chance of a 50 basis points reduction, and a 46% chance of a 75 basis points cut.

Cuts of Necessity vs. Cuts of Choice

Historically, during a “soft landing” scenario, which is relatively rare, the Fed has typically implemented a total rate cut of 75 basis points on average. This highlights the distinction between cuts of necessity and cuts of choice.

The Summary of Economic Projections released after the December Federal Open Market Committee meeting reflected a median expectation for three Fed rate cutsWhen the Fed cuts rates, it reduces the cost of borrowing for consumers and businesses, which can stimulate spending and investment. Fed rate cuts also have consequences that affec... More, totaling 75 basis points, throughout the year. This suggests that the Fed anticipates making these cuts as a matter of necessity rather than choice.

Fed Governor Chris Waller’s Perspective

Fed Governor Chris Waller recently emphasized this distinction when he mentioned that he saw no reason for the Fed to rush into early or rapid rate cuts. He pointed out that in previous economic cycles, when shocks to the economy threatened or caused recessions, the FOMC reacted by quickly and substantially cutting rates.

However, in the current economic environment, where economic activity and labor markets remain strong and inflation gradually reaches the 2% target, Waller sees no need for swift or substantial rate cuts. This stance suggests that the Fed is more inclined to make cuts of choice rather than necessity, taking into account the overall health of the economy.

In conclusion, the market’s expectations for rate cuts in the near future are high, but the Fed’s decisions should be evaluated in the context of the economic conditions and whether these cuts are reactive or proactive. Fed officials, like Chris Waller, are cautious about making rapid rate cuts when the economy is in good shape, which suggests that the path of future rate adjustments will depend on a careful balance between economic indicators and policy goals.