The interest rate environment over the past nine months has resembled a pendulum as markets (and Fed officials themselves) attempt to shift from a hiking to an easing regime, normalizing the federal funds rate closer to the long-term neutral target. As we wrote in last week’s note, the Fed faces a conundrum of normalizing interest rates from the current 5.5% upper bound to their neutral target while tempering the threat of inflation.
While last week’s FOMC decision did not result in any explicit Fed policy changes, the “dot plots” produced a hawkish outcome with a median projection of one policy rate cut in 2024, lower than our base case projection of two rate cuts and down from a median projection of three rate cuts during the March FOMC.
Eleven members of the committee projected zero or one interest rate cut, while eight members forecasted two cuts, so it was a close call, and Fed Chair Jerome Powell echoed as much during his press conference. Referring to the possibility of one or two cuts for the remainder of this year, Powell stated: “…I can’t really distinguish between two of these. They’re so close for me. These are very close calls.”
Recent (dis)inflation readings open the door to rate cuts starting in the fall. The CPI reading for May –much lower than consensus with the core reading at its slowest pace in nearly three years – drove interest rates lower, which remained the case despite the hawkish surprise from the Fed. Rates markets are pricing in a 65% probability of the first rate cut taking place in September with two total cuts for 2024.
One of the more interesting takeaways from the June FOMC meeting was the increase in the projected “longer run” fed funds rate, for which the median estimate rose to 2.75% from 2.56% in March. The median longer run estimate, also known as “R-star”, had been anchored at 2.5% since 2019 before starting to rise in March. The strength of the US economy in the face of higher rates as well as predictions of higher structural inflation (due to a capital expenditure boom, deglobalization, etc.) have sparked the notion that the target fed funds rate should be higher than 2.5%, which is reflected in market pricing. The FOMC has started to acknowledge the reality of a higher target fed funds rate now through their official forecasts, and we expect this discussion continue to grow in intensity over the coming years.
The Fed looks to be on track to cut interest rates this year, supported by recent inflation readings. While the US economy remains in expansion, we believe labor market and consumer data have scope to surprise to the downside in a world where risk assets and credit are priced at valuations that leave little room for error. We continue to view the distribution of outcomes for interest rates over the next 12 months to be skewed to the downside.
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