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.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk, including loss of principal.

Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results, and the opinions presented cannot be viewed as an indicator of future performance.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.

Commodity-related products carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, may be illiquid, and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.

Futures and futures options trading involves substantial risk and is not suitable for all investors. Please read the Risk Disclosure Statement for Futures and Options prior to trading futures products.

Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg’s licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.