Sticky inflation brings Fed rate cuts into question

by George Brown | 28,May,2024 | Investments, Q2 2024, Schroders

George Brown

The Federal Reserve is unlikely to cut rates as previously expected in June and it is now a close call whether it will cut at all in 2024. Heightened risks in the Middle East add a further element of uncertainty.

Will the Federal Reserve cut rates this year? It is the question every investor is asking after core inflation surprised to the upside in March for the third consecutive month. Futures markets now point to fewer than two rate cuts in 2024, having priced in as many as six or seven back in January.

The change in market expectations has not been met with any pushback from Fed chair Jerome Powell. Following the March inflation print he has admitted it is “likely to take longer than expected” for the central bank to have the confidence to start easing policy.

It is now a close call whether any easing materialises this year. Any cuts will be conditional on there being conclusive evidence that inflation is converging back to target. Not only will this require a softening in sequential inflation, it will also hinge on labour market conditions coming into better balance.

For South Africa in particular, there doesn’t seem to be much hope on the horizon anytime soon. David Rees, our Senior Emerging Markets Economist, has said that while central banks in many major emerging markets have been able to start lowering interest rates, the South African Reserve Bank has been forced to maintain the repo rate at 8.25% over the past year. “It seems unlikely that the country’s rates will be cut anytime soon amid a perfect storm of sticky domestic inflation, uncertainty about the outcome of the general election and dislocation in global markets following concerns about inflation in the US and tensions in the Middle East.

 “Higher for longer local interest rates will remain restrictive for activity, meaning that economic growth in South Africa is likely to suffer.”

Could groundwork for cut be laid at Jackson Hole in August?

Another factor that could delay any rate cuts is a significant escalation of the situation in the Middle East. Our latest economic forecasts included a risk scenario in which a conflict erupts in the region, dragging in Western nations.

Such a scenario would disrupt key shipping channels as well as the supply of oil, pushing up global energy and goods prices. Given concerns about tight labour markets and second-round effects on wages, this would prompt central banks to push back the start of any easing cycles.

This risk aside, there is unlikely to be sufficient progress in either the inflation prints or jobs data to give the Federal Open Market Committee (FOMC) confidence to cut rates by their June or July meetings. We suspect there might have been enough progress by the time the Fed’s rate setting committee gathers in September.

The groundwork for a policy easing could be laid by Powell in his keynote speech at the Jackson Hole economic symposium in August. A September rate cut would also come with the added advantage of being accompanied by an updated ‘dot plot’, which the FOMC could use to telegraph their expectations about the timing and extent of any easing.

Our expectation is that this would be followed by two more rate cuts at the December and March meetings.

However, we still believe the committee will subsequently struggle to justify cutting rates further. Inflation should then be at target, while unemployment is likely to remain low, meaning the FOMC ought to have achieved its dual mandate of price stability and full employment.

This three-cut cycle would deliver a cumulative 75 basis points (bps) of easing, the same as that overseen in 2019, which itself was modelled on the mid-cycle adjustment made in the mid-1990s.

US election may impact timing and extent of easing

But the balance of risks is clearly tilted towards later and fewer cuts. While the evolution of the data will be the overriding determinant, we don’t discount the possibility that the election on 5 November might impact the timing and extent of any easing.

For instance, the FOMC might wait until the December meeting to either cut rates by 50 bps or hold them unchanged, depending on whether the election outcome is expected to have a material impact on the economic outlook.

There is also a decent likelihood that the FOMC does not ease policy at all this year. We now place a 40% probability on such a scenario; a risk that we think is currently being underpriced by the market. And if inflation starts to re-accelerate, the next move from the committee might not be a cut, but instead could be a hike.

George Brown
Senior US Economist at Schroders | + posts