FORECASTS & TRENDS E-LETTER
By Henry Rohlfs
August 27, 2024

Fed to Cut Rates By 2%?

IN THIS ISSUE:

1.  The Time Has Come

2.  Up Like a Rocket, Down Like a Feather

3.  Real Fed Funds Rate

4.  Neutral Interest Rate

5.  The Bottom Line

Last Friday at the close of the Jackson Hole Economic Policy Symposium, Federal Reserve Chair Jerome Powell said it was time for the Fed to make a major shift in policy.

“The time has come for policy to adjust,” Powell said. “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

Recent economic data have shown that since 2022, the inflation rate has fallen from a 40-year high almost back to pre-Covid levels. At the same time, the unemployment rate has steadily risen, fueling worries that the economy could enter a recession if interest rates stay high.

Major market indexes welcomed the news with moves upward. There are many on Wall Street who are ready to price in interest cuts of up to 0.75% by the end of 2024.

But one analyst believes the Federal Reserve will cut rates by up to 2% in the coming months. We’ll take a look at his reasoning and make our own prediction of how quickly the Fed will move.

The Time Has Come

Inflation has fallen to around 2.5% from above 7% two years ago, close to the Fed’s 2% target. But the unemployment rate has drifted higher to 4.3% in July from 3.7% at the beginning of 2024. While that’s still a historically low level, it won’t necessarily stay there.

The real question now is how the Fed plans to go about cutting interest rates, and if it can find a path that won’t be inflationary or allow the labor market to weaken too much. The Fed had made considerable progress in reducing the inflation rate, which continues to fall along a bumpy route toward its 2% target, but there’s always a risk that interest rate cuts could generate new inflationary pressures, especially in housing, which has been a persistent problem.

We also need to look at the other side of the Fed mandate coin. Last week’s downward revision of job growth data suggests the labor market is not as strong as previously thought. The Fed understands that once the unemployment rate begins to move, it can run up in a hurry.

 

 

 

 

 

 

 

Up Like a Rocket, Down Like a Feather

Inside the Fed, some are reportedly pushing for faster rate cuts since the labor market appears to be softening. “In regular business cycles, unemployment goes up like a rocket but comes down like a feather,” Chicago Fed President Austan Goolsbee told the Wall Street Journal, adding that while the post-pandemic economy has been unusual, “it’s at least a note of caution that the job market has been cooling. It needs to stop cooling.”

“If job openings fall a lot more, people who lose their jobs are not going to be able to walk across the street and find work,” said Peter Berezin, chief global strategist at BCA Research.

The current consensus is that the Fed will cut rates by a quarter of a percentage point in September, with the CME Fed Watch tool giving that outcome a 70% probability. Powell’s comments Friday pointed in that direction, while maintaining as much freedom of movement as possible in case new data suggest the central bank should move faster or slower.

Real Fed Funds Rate

Last Friday, Wells Fargo chief economist Jay Bryson told CNBC that the Fed will cut rates by 50 basis points in September, another 50 bps in November, and 25 bps in December. That’s right – 1.25% by the end of 2024. And he predicts another three-quarters of a point cut by mid-2025.

He argues that Fed policy is very restrictive and has been for an extended period. Inflation is close to the Federal Reserve’s target of 2% and the jobs market is weaking. He sees the Fed making bold interest rate moves as they shift in policy.

Bryson went on to say, “We measure [how restrictive] by the so-called ‘real fed funds rate’ – the nominal rate minus inflation, and that’s close to 3% right now. We haven’t been at these levels since 2007.”

The question is why a 3% real fed funds rate is important. Let’s define what Bryson is talking about.

The real federal funds rate is the effective federal funds rate (EFFR) minus the 12-month core inflation rate, as measured by the Personal Consumption Expenditures index (PCE). Right now, the EFFR is 5.33%, which changes slightly each day but has remained at about the midpoint in the 23-year high of 5.25%–5.50%. At last reading, the PCE core index was at 2.6%. That gives us a real federal funds rate of 2.73%.

Neutral Interest Rate

For years Fed economists have tried to estimate what the short-term interest rate would be when the economy is at full employment and stable inflation – an economy that is not expanding or contracting. They call this the neutral rate of interest. In 2023, Federal Reserve economists put the real (inflation-adjusted) neutral rate at about 0.6% in the United States.

So Bryson’s point is that the Fed needs to drop the EFFR over 2% to reach the neutral rate. Most economists also think along the same lines. However, they believe that Powell and company will be more cautious and enact lower interest rates gradually over the next two years.

In sharp contrast, Bryson gives his reasoning behind the dramatic rate decrease as follows. “When you look at history the Fed funds rate tends to move a lot in a direction rather than going 25 basis points, waiting a meeting or two, then going another 25 basis points. The big swings are more normal. [Emphasis mine.]”

The chart above shows interest rate changes since the 1950s. The shaded areas are U.S. recessions. To Bryson’s point, the Federal Reserve does tend to dramatically change interest rates. But the way I see it, big rate drops only occur to counteract recessions, and not simply done by course. If the U.S. economy was clearly in recession, multiple 50-basis point interest rate cuts could be in order. However, consumer spending remains vibrant and the Atlanta Fed’s GDPNow model estimates growth to continue at 2.0%.

The Bottom Line

If the Fed wants to stick the soft landing, they will need to continue their cautionary pace. I’m in line with the 70% chance of a 25-basis point rate cut as reported by the CME Group. Chair Powell has consistently kept his options open regarding the timing and speed of rate cuts. Officials could cut rates by a quarter-point at each of their next few meetings and then dial up or down the size and speed of reductions depending on how the economy fares early next year.

Chicago Fed President Goolsbee emphasized this point. “The reason you move gradually as a central banker is it gives you optionality.”

The Q2 GDP second estimate will be released Thursday and the July PCE index will be posted Friday. In the unlikely case that these values change dramatically from their current values, we could see Jay Bryson’s prediction fulfilled. But I don’t see that happening.

All the best,

 

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