Fed rate cut shows main battle against…

In the end, the Fed went with the larger 50 basis point cut. But that doesn’t mean the Fed was trying to shock the markets.

Indeed, the FOMC’s updated forecasts imply that the Fed will move to a more gradual pace in future meetings, including cutting by 25 basis points in the last two meetings in 2024. In addition, the Fed’s projections call for a 2025 Fed year-end – funds rate of 3.25%-3.50%. While this is a significant reduction from previous projections of 4.00%-4.25% at the end of 2025, it is a step above recent implied market expectations of a federal funds rate of 2.75%-3.00% at the end of 2025.

In fact, the Fed suggests that the market has already anticipated broad expectations for a Fed rate cut, and there is no need (for now) for those expectations to fall further.

Expectations for the federal funds rate are the main driver of bond yields. As interest rate cut expectations intensified, the two-year Treasury yield fell to 3.6 percent in mid-September from 4.5 percent at the end of July 2024. The 10-year Treasury yield fell, also up about 50 basis points over that period. This matters because the level of bond yields along the curve is even more important than the level of the federal funds rate in determining the overall impact of monetary policy on the economy.

Bond yields barely moved in Wednesday’s decision, highlighting the Fed’s desire not to overturn current market expectations.

How to justify a big interest rate cut?

Still, this begs a question: Why did the markets and the Fed shift so drastically to believe that more aggressive interest rate cuts would be appropriate? Over the past few months, we have seen mild inflation data continue to emerge. Powell noted that headline PCE inflation was likely to be 2.2% year-over-year for August, roughly in line with the Fed’s 2% target. Meanwhile, the labor market has become more concerning, with unemployment rising more than 0.5 percentage points over the past 12 months and nonfarm payrolls growth decelerating. Economic activity continues to expand at a healthy pace according to gross domestic product data, although anecdotal data from the “Beige Book” survey is more worrisome.

Overall, Powell noted that “risks to meeting the employment and inflation targets are balanced,” after high inflation has been the overriding concern for the past two to three years. To elaborate, this means that continued concerns about returning inflation to the Fed’s 2% target (which would require restrictively high interest rates) are equally balanced by concerns that the economy and labor market could slide into a recession (which would require low interest rates). interest rates).

Where next for interest rates?

With these two factors in balance, that calls for a federal funds rate much closer to its “neutral” level. The exact level of neutral is uncertain, but it is believed to be around 2%-3%, according to Fed officials. The 50 basis point cut makes more sense when considering the large divergence between a neutral rate of 2%-3% and the pre-existing federal funds rate north of 5%.

We believe the federal funds rate is likely to follow a course consistent with today’s FOMC forecasts at least through the end of 2025. This amount of monetary easing should be sufficient to keep the economy in a recession. The increase in unemployment is far from alarming in our opinion. With GDP still growing solidly, we find it hard to believe that the job market will spontaneously fall off a cliff. This should keep Fed cutting at a more measured pace in future meetings.