LGOV - Fed Will Be Slow To Cut Interest Rates In 2024
2024-01-15 20:07:00 ET
Summary
- Underpinning the Fed’s policies will be the basic data on the economy regarding the risk of recession and the movement of inflation.
- Consumer Price Index rose just 3.4% over the past 12 months, down from a peak of 9.1% in mid-2022.
- Long-term rates are set by bond and securities traders weighing current short-term interest rates and expected long-term rates.
The Federal Reserve will start cutting interest rates around mid-year 2024, but the cuts will be slow and gradual. Bond and mortgage rates will move earlier in anticipation of the Fed’s change in short-term interest rates.
Underpinning the Fed’s policies will be the basic data on the economy regarding the risk of recession and the movement of inflation. The risk of recession has fallen, according to the judgment of economists. The Wall Street Journal’s survey showed an average estimate of the risk of recession of 39% in January 2024 compared to 61% a year earlier.
Reinforcing the view that recession is unlikely has been the continual increases in employment. The U.S. has not had a single monthly decline in jobs since 2020, and the latest months’ gains have been moderate. Two job-related warning signs are showing green. The median duration of unemployment spells stands at 9.7 weeks, just a little higher than the 2019 average. And initial claims for unemployment insurance averaged under 210,000 in recent weeks, well below the historical average.
The second set of data important to Fed policymakers concern inflation. The headline-grabber, Consumer Price Index , rose just 3.4% over the past 12 months, down from a peak of 9.1% in mid-2022. The Fed prefers to look at the personal consumption expenditures price index excluding food and energy. It grew by 3.2% in the most recent 12 months, down from a peak of 6.5%. The Fed’s target is two percent.
The inflation data tell the Fed their work is almost done, but the employment data tell them there’s no urgency. In addition to the recent data, though, the Fed has a particular view of how the economy works, with three key aspects. First, inflation has proved very hard to forecast in recent years. The Fed undershot their target in the pre-pandemic years, then hugely overshot in 2021 and 2022. Nobody’s inflation-forecasting models have worked well. So the Fed will be cautious when reviewing their staff forecasts of further declines in inflation.
The second of the Fed’s key economic viewpoints is that several factors that may have delayed the effect of tighter monetary policy on spending (described in the third paragraph of my economic forecast article ). The Fed is not positive that the recession has been prevented rather than delayed.
The third important economics issue is the importance of getting inflation low. Most if not all Fed policymakers believe that allowing inflation to continue above the target would lead to behavioral changes by consumers, businesses and investors, and then a severe recession would be needed to bring inflation down.
All told, there’s no urgent need to cut, as far as the Fed can see right now, and good reasons to be cautious. That is what the Fed will do most likely. They will probably cut short-term interest rates by a quarter of a percent at either their June or July 2024 meeting. Thereafter, they will cut rates by a quarter percent two more times in 2024, continuing the process in 2025. Their final position will probably be about two percent on short-term interest rates.
Long-term rates are set by bond and securities traders weighing current short-term interest rates and expected long-term rates. The recent peak for the 10-year Treasury bond was 4.98%, hit in October 2023. Recent yields have been around 4.0% (as of this writing), reflecting expectations that the Fed will begin cutting short-term rates this year. If those expectations are met, then four percent could be our average rate for the next two years.
Mortgage rates have an additional twist, in that potential buyers of mortgage-backed securities are worried about pre-payment risk. If current mortgage rates are high but expected to drop, then prepayments will rise when mortgage rates fall. That means that an investment-backed security is really a short-term investment. And right now, short-term interest rates are higher than long-term rates. So the spread between mortgage rates and Treasury bond rates is now unusually large. Over time, however, that spread will return to its historical average, which will bring mortgage interest rates down to about six percent.
Uncertainty about interest rates in the near future is high, so this forecast should be taken with a grain of salt. The key is how the incoming data conforms—or doesn’t—to the Fed’s expectations.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Fed Will Be Slow To Cut Interest Rates In 2024