On Sept. 18, the Fed is expected to cut rates for the first time since it began raising them in March 2022. Although many consumers and businesses are looking forward to the monetary policy adjustment—especially those paying high interest rates on debt—experts say the Fed is likely to take a cautious approach.
"The economy isn't falling apart so the Federal Reserve has time to get rates down," said BOK Financial® Chief Investment Officer Brian Henderson. "They're probably going to start off fast with cuts of 25 basis points (0.25%) each in September, November and December, and then may slow to one rate cut per quarter in the new year."
Cutting in small increments also leaves the door open for the Fed to make larger cuts of 0.5% each if the economic situation worsens; however, right now, Henderson doesn't foresee that happening.
"I don't see the economy falling off the rails. Labor demand is slowing, but overall gross domestic product (GDP) growth has been good."- Brian Henderson, BOK Financial chief investment officer
Recession still unlikely, despite weakening job market
"I don't see the economy falling off the rails. Labor demand is slowing, but overall gross domestic product (GDP) growth has been good," he said. Although the labor market continues to cool, with employers once again adding fewer jobs than expected, that shouldn't necessarily set off alarm bells yet, he explained.
Still, the Fed will continue watching job figures—and inflation—closely. "I think it haunts them that historically the Fed doesn't have a great track record with cutting rates soon enough," Henderson said. "They know that when the unemployment rate starts to go up, it tends to stay up and feed on itself."
"When consumers and businesses start to see people losing their jobs, they tend to want to clamp down and slow their spending," he continued. "This then leads to even higher unemployment rates, so that's in the back of the Fed's mind."
Fed Chair Jerome Powell himself called the cooling labor market conditions "unmistakable" while speaking at the Jackson Hole economic symposium at the end of August. He also spoke of how much inflation has come down and said that the "time has come" for a monetary policy adjustment.
Henderson agrees that cutting rates now makes sense. Inflation should continue to trend downward in the months ahead, as long as gasoline prices stay low, which is another factor that Henderson expects will support a rate cut decision.
Inflation is already much closer to the Fed's 2% target than at its peak in June 2022. Year-over-year, it was 2.5% in July, according to the Personal Consumption Expenditures (PCE) price index, while core PCE inflation (excluding food and energy prices) was at 2.6%.
Path to ‘neutral' rates could be long
As the Fed cuts rates, they're moving toward what's considered a "neutral" Federal Funds rate—meaning a rate that is neither accommodative nor restrictive to economic growth. It's unclear what exactly this neutral rate is, but it's probably around 3.5%, Henderson said.
By comparison, the current Federal Funds rate of 5.25% to 5.5% is considered to be restrictive. The Fed has kept it at this level to slow the economy enough to bring down inflation from its post-pandemic peak.
"The Fed thinks current monetary policy is very tight—that the Federal Funds rate is slowing down growth and demand while helping to lower inflation," Henderson said. "There are questions about how tight it is, but it is having an impact."
Declining inflation, coupled with rising unemployment, has fueled financial markets' projections of future rate cuts. The bond market has been projecting as many as nine cuts of 0.25% each by the end of 2025, but Henderson believes that figure may be too high. "That's basically pricing in a recession," he said. Instead, if a recession or sharp economic downturn doesn't occur, it could be as long as two years before the Federal Funds rate reaches a neutral level, he noted.
Some factors impacting jobs and inflation are outside the Fed's control
There are also some structural issues in the economy that are outside the Fed's control, Henderson said.
Many of those issues are concerning the labor market. For instance, much of the recent rebalancing of the labor market is due to more relaxed immigration policies after the pandemic and increased labor force participation.
"It's difficult to see those numbers going a whole lot higher," Henderson said. Meanwhile, as more and more Baby Boomers retire, the number of available workers will continue to decline.
Additionally, there are structural issues in the energy market to consider, he added. Although lower gasoline prices have been a large factor driving down inflation and will likely continue to do so in the near-term, the current geopolitical environment makes it unlikely that gas prices will stay as low as they have been in the longer term. If gas prices move higher, that could raise inflation.
"Powell didn't mention those things in his speech at Jackson Hole, but we see them as a risk to cutting rates too quickly while the economy isn't slowing down as much," Henderson said.
How to prepare for a normal yield curve
When the Fed starts cutting rates, the action will continue to un-invert the yield curve, which already has started to normalize based on anticipations of rate cuts, Henderson noted. Once it fully goes back to normal, investing in longer-term debt will generate higher income than investing in shorter-term debt—the opposite of what has been occurring during the period of inversion.
"Yields on overnight investment vehicles like money market funds will drop almost immediately," Henderson said of the first rate cut's expected impact. "Investors who don't need to have as much money in overnight funds should be looking for opportunities to extend maturities and duration."
However, that doesn't necessarily mean that investors have to act right away, as the situation may change, he noted. "There is the potential that the market will start doubting the Fed's ability to cut rates as much as what's currently projected."
. © 2024 BOKF, NA.