SPXT - Federal Reserve Policy: Piloting A Smooth Landing

2024-01-12 22:35:00 ET

Summary

• Federal Reserve policy rates are set to fall in 2024. However, clear evidence that inflation has been tamed likely needs to emerge before cuts can commence, likely around mid-year.
• While a smooth landing is still far from certain, rate cuts accompanied by recession avoidance would present a constructive backdrop for risk assets in the year ahead.
• Make no mistake, it will still be a challenging policy landing. Cutting policy rates too soon risks reigniting inflation. Cutting policy rates too late risks recession.

By Seema Shah, Chief Global Strategist

Federal Reserve policy rates are set to fall in 2024. However, clear evidence that inflation has been tamed likely needs to emerge before cuts can commence, likely around mid-year.

While a smooth landing is still far from certain, rate cuts accompanied by recession avoidance would present a constructive backdrop for risk assets in the year ahead.

Real Fed funds rate

January 2009–present

*Assuming Fed funds held at 5.5% and using Headline CPI forecast. Source : Federal Reserve, Bureau of Labor Statistics, Bloomberg, Principal Asset Management. Data as of December 31, 2023.

Core U.S. CPI inflation has fallen below 4%, opening the door to Federal Reserve (Fed) rate cuts this year. Of course, the inflation journey is not yet over, but the Fed has a solid chance of bringing inflation back to target without triggering recession.

Make no mistake, it will still be a challenging policy landing. Cutting policy rates too soon risks reigniting inflation. Cutting policy rates too late risks recession.

To stick the landing, the Fed will need several months of data showing inflation is sustainably en route to the 2% target. Once it has secure evidence, likely to come in 2Q, the Fed will want to act promptly.

After all, if the Fed were to keep policy rates on hold at 5.5%, falling inflation would imply a rising real policy rate and, therefore, a tightening monetary stance.

Given inflation's current path, the Fed will need to cut policy rates to maintain the same level of monetary restriction in real terms.

Historically, the Federal Reserve has tended only to ease monetary policy once signs of a recession emerge.

In this unusual economic cycle, still in the pandemic's shadow, rate cuts accompanied by an economic slowdown - not recession - is a high possibility, presenting a constructive backdrop for risk assets.

Even so, considering broad equity and credit valuations are stretched, investors must carefully seek opportunities.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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