The Fed Hesitates and the Markets Wait

March 6, 2024 Kathy Jones
Although a strong economy has changed expectations about the timing and magnitude of interest rate cuts, we still see room for the Federal Reserve to cut by three-quarters of a point this year.

In the past few months, expectations about the timing and magnitude of interest rate cuts by the Federal Reserve have changed dramatically. Earlier in the year, the federal funds futures market had priced in as many as six 25-basis-point1 cuts to the federal funds target rate, suggesting that the upper bound of the rate would fall from 5.5% to 4.25% this year.

Now that number is down to three, implying a year-end federal funds rate of 4.75%. Some are even suggesting that the Fed won't lower interest rates this year at all, due to the strength of the economy and the risk that inflation will remain too high.

One reason for the volatility in expectations is that the Fed has pushed back on the prospect for a rapid pace of rate cuts. Rather, it has indicated that it is "data dependent," watching every data point to assess the next policy move. That leaves investors to react to every economic indicator and extrapolate the results into the future. However, taking a long-term perspective, we still see room for the Fed to cut rates three times for a cumulative total of 75 basis points in 2024.

Inflation is trending lower

Various indicators point to lower inflation over the long run. The indicator that the Fed uses for setting policy, the deflator for personal consumption expenditures excluding food and energy (core PCE) is nearing the Fed's 2% target level and trending lower. The recent increase was driven to a large extent by rising fees for financial services, an outgrowth of the bull market in stocks leading to increased trading fees. While the bull market can continue, we doubt large monthly increases in fees are likely to be sustained going forward.

Despite a stronger-than-expected rise in core PCE in February, the overall trend remains lower

Chart shows the year-over year change in core PCE, along with the 6-month annualized and the 3-month annualized changes. As of January 31, 2024, the year-over-year change was 2.9%, the 6-month change was 2.5% and the 3-month change was 2.6%.

Source: Bloomberg, using monthly data as of 1/31/2024.

US Personal Consumption Expenditure Core Price Index MoM SA (PCE CORE Index).

Meanwhile, prices at the wholesale level show little sign of inflation pressures. Producer Price Index (PPI) readings for both goods and services remain low.

Producer prices show little sign of inflation pressures

Chart shows the year-over-year percent change for various types of producer prices: all commodities, finished goods less foods and energy, and final demand services. As of January 31, 2024, all commodities prices were down 3.7% year over year, and the other two categories were up 2.4% and 2.2%, respectively.

Source: U.S. Bureau of Labor Statistics, monthly data as of 1/31/2024.

Producer Price Index by Commodity: All Commodities (PPIACO), Producer Price Index by Commodity: Final Demand: Finished Goods Less Foods and Energy (WPSFD4131), Producer Price Index by Commodity: Final Demand: Final Demand Services (PPIDSS). Percent Change from Year Ago, Seasonally Adjusted.

Economic growth with productivity is not inflationary

An additional concern is that economic growth has been more resilient than expected in the face of Fed rate hikes. Inflation-adjusted, or "real," gross domestic product growth has averaged more than 4% over the past two quarters, the strongest pace since the rebound from the pandemic-led decline. Moreover, recession fears have abated. There are fears that stronger economic growth could lead to a rebound in inflation pressures. However, there has been a surge in productivity growth behind those numbers, which is not inflationary because it indicates that workers are generating more output per hour.

Productivity growth has increased

Chart shows the quarter-over-quarter percent change in U.S. labor productivity going back to 2014. Productivity has increased during the last two quarters of 2023.

Source: Bloomberg, quarterly data as of 12/31/2023.

U.S. Labor Productivity Output per hour Nonfarm Business Sector (PRODNFR% Index). Note: This concept tracks the total output that can be produced with a given input of labor. Generally, it is measured by dividing total real gross domestic product by either total employment or total hours worked.

Fed policy is tight enough

By most measures, the Fed's policy interest rate is high enough to keep inflation in check. The real federal funds rate (fed funds adjusted for inflation) is the highest it has been since 2007. While the economy has managed to do well despite rate hikes, the real rate would rise if inflation continued to edge lower. There is little reason for the Fed to keep rates high as long as inflation pressures are subdued.

The real federal funds rate is at the highest level since 2007

Chart shows the real federal funds rate dating back to 2000. As of January 31, 2024, the rate was 2.4%, the highest level since 2007.

Source: Bloomberg, monthly data as of 1/31/2023.

Federal Funds Target Rate Upper Bound (FDTR Index) minus Core PCE: US Personal Consumption Expenditures Ex Food & Energy Deflator SA (PCE CYOY Index).

Moreover, looking at the various policy rules that the Fed takes into consideration, the current setting of the fed funds rate is high. A useful gauge is the "Taylor Rule," which estimates a target federal funds rate based on inflation and economic data, such as the output gap. It has been modified over the years. As the chart shows, the current fed funds rate is above the levels indicated by the various Taylor rules, which opens the door to the potential for rate cuts of 75 to as much as 200 basis points over the next year.

Actual federal funds rate and Taylor rule alternative scenarios

Chart shows the actual federal funds rate dating back to 1984, with three separate links showing how various Taylor rule alternative scenarios would have affected the rate.

Source: Chart and Table, Federal Reserve Bank of Atlanta Taylor Rule Utility using data as of 2/29/2024.

Note: The Taylor rule is an equation John Taylor introduced in a 1993 paper that prescribes a value for the federal funds rate—the short-term interest rate targeted by the Federal Open Market Committee (FOMC)—based on the values of inflation and economic slack such as the output gap or unemployment gap.

Volatility and opportunity

The sudden shifts in market expectations about the direction of interest rates can be unsettling. However, through the volatility, potential opportunities have emerged. We continue to believe that high quality, intermediate-term bonds offer attractive yields relative to the risk. Investors with a long-term time horizon should consider allocating to core bonds (Treasuries, other government-backed bonds, and investment-grade corporate bonds) at current yields of roughly 4.5% to 5.5%.2 The Fed may be hesitating to cut rates, but we continue to see room for yields to fall.

1 A basis point is a unit of measure for interest rates and other percentages in finance. One basis point is equal to one one-hundredth of 1%, or 0.01%.

2 Source: Based on the yields for the Bloomberg US Aggregate Bond Index and the Bloomberg US Corporate
Bond Index as of 3/6/2024.

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