We expect a soft landing for the US economy, which is supportive for risk assets.
The US Federal Reserve (Fed) cut the federal funds rate by 50 basis points, from 5.5% to 5%, after more than two years of tightening conditions to combat the highest US inflation since the 1980s.
This rate hike was intended to cool the US economy and combat inflation. The first rate hike was announced in March 2022, exactly one year after Fed Chairman Jerome Powell said that “these one-off price increases are likely to have only transitory effects on inflation.”
The U.S. Consumer Price Index (CPI) peaked at 9.1% year-over-year in June 2022 and has risen 23% since pre-COVID (an acceleration not seen since the 1970s). The chart below shows that U.S. citizens are now suffering from consumer prices that are 13% higher than the Fed’s 2% inflation target projections since the pre-COVID levels that caused the shock.
The Fed got it wrong, which is why it is being criticized for being late in raising rates. The following chart shows that in the current cycle, the first hike (1) came late after inflation had picked up (2), unlike in previous cycles.
In 2022, it seemed that the Fed had to choose between keeping inflation high (i.e., not raising rates enough to slow the economy) and inducing a recession (by raising rates too much). The worst-case scenario would have been stagflation (no economic growth coupled with inflation), a situation in which cutting rates would have fueled inflation and raising rates would have caused a recession. The idea of a soft landing (meeting the inflation target and avoiding a recession) seemed utopian to most at the time.
Although disinflation has been achieved so far (slowing the pace of price increases from a peak of 9.1% to 2.5% year-on-year), Mr. Powell has repeatedly asserted that the fight is not over until the 2% annual inflation target is reached.
Every time the Fed has cut rates in the past, it has been because of deteriorating economic conditions that were reflected in weak stock markets. 2024 may be an exception to this rule that goes back more than 50 years of US monetary policy. Indeed, the Fed has cut rates despite no significant signs of a slowdown in the US economy (although pressures on the labor market have increased), or of a recession. Correlation does not mean causation; this time, the rate cuts may not be accompanied by a fall in stocks. The US economy is still expected to grow by 2.5% in 2024 and 1.7% in 2025 in real terms, according to the market consensus.
There are few examples of the Fed successfully landing softly after tightening cycles of more than 250 basis points. In the mid-1960s, economic growth continued for several years before the 1970 recession. In 1983-84, growth persisted until a recession finally occurred in 1990, and after 1994-95, growth even accelerated until it plunged in 2001. But the aftermath of a tightening cycle usually ends with an inevitable recession in the following quarters.
The Swiss National Bank was the first central bank in developed countries to cut rates in 2024. China’s did so in mid-2023 in an attempt to revive its economy. Europe’s was autonomous and also cut rates this year independently of the Fed’s decisions, in a context of slowing growth in the region. Since then, most central banks have followed suit.
The challenge ahead for the Fed is to avoid a policy mistake, that is, cutting rates too quickly or too slowly. It is hard to believe that the ghost of the Volcker era is not haunting Powell, who would not want to repeat the same mistake he made when he cut rates in the 1980s, triggering a second wave of even stronger inflation.
The Fed’s updated chart shows an additional 50 basis points of rate cut by the end of 2024 and 100 basis points in 2025 (to 3.4%), before settling at 2.9%. Markets are now pricing in 75 basis points of rate cuts in 2024. Market data matters in the short term, but it is difficult to trust 2-3 year expectations because precise economic conditions are unknown and the further into the future, the more uncertain they are.
Time will tell whether the Fed, after being slow to raise rates, has arrived in time to reduce and achieve a soft landing. Economic uncertainty could increase in the future due to the US presidential elections. The Fed’s actions could vary depending on the president-elect’s agenda.
The market reaction to Powell’s comment was muted. Changes in the Fed’s statement from June included slowing job gains and greater confidence among Fed members that U.S. inflation is converging toward the 2% target. The risk of an upside to inflation has diminished and the risk of a downside to unemployment has increased, hence the 50 basis point rate cut. A narrow majority of Fed members expect another 50 basis point rate cut in 2024. The Fed will also continue to shrink its balance sheet at the same pace. Finally, Powell emphasized the Fed’s commitment to maximum employment.
The net effects on the US economy and markets depend on the Fed’s overall policy, which includes liquidity injections and the size of the Fed’s balance sheet. We can therefore interpret yesterday’s reduction as a hawkish move, given that no change was made to balance sheet reduction and Powell insisted that 50 basis points was not a standard for future actions. The chart below shows that the Fed reduced its balance sheet by 20%, which is still 70% higher (40% in real terms) than pre-COVID levels and 700% higher (450% in real terms) than pre-2008 levels.
Our analysis of the medium-term effects has revealed once again that it is rather favorable to the markets. Indeed, it has met the expectations of the markets and we believe it will continue to do so. We expect a soft landing for the US economy, which is favorable for risk assets. The impact on bonds is more ambiguous, with a risk of a curve retreat in the event of a resumption of inflation. The impact on the US dollar could be a depreciation against currencies whose central banks have a more hawkish tone.
Sources: Bloomberg
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