Markets brief: Will the Fed really cut rates 5 times next year?

The RBA held interest rates steady yesterday and speculation is rife on when interest will come down in Australia. The interest rate policy of the Federal Reserve in the US also has a large influence on Australia. Interest rate policy impacts the world’s largest economy but also influences the Aussie dollar which has been weak lately which is partially based on the interest rate differential between Australia and the US.

Market watchers are looking ahead to 2024 for clues about the path interest rates will take. That will depend largely on the trajectory inflation takes. Economists expect the Federal Reserve to begin cutting interest rates at some point next year, but there’s no clear consensus on when, or by how much.

The Fed began a steady campaign of rate hikes in March 2022, when inflation was approaching its highest level in four decades. Now, with more than 5 percentage points of hikes in the rearview mirror and a target federal-funds rate between 5.25% and 5.5%, the picture looks much healthier. August jobs data released Friday showed signs of cooling in the labor market, which is another sign that the Fed’s hiking campaign is having its intended effect.

When will the central bank start pumping the brakes? Traders and economists generally agree that cuts aren’t coming this year, but next year is a different story.

“2024 is supposed to be the year when the Fed will not be aggressively raising rates anymore, and will in fact be more accommodative,” says Lawrence Gillum, chief fixed-income strategist at LPL Financial. He says traders are already trying to get ahead of rate cuts, and their bets on rates in 2024 are already reflected in futures trading.

How much will the Fed cut interest rates in 2024?

As of Sept. 1, futures prices indicate that traders anticipate about 1.2 percentage points of rate cuts next year, according to Bank of America rates strategist Meghan Swiber. If the Fed lowers rates a quarter-point at a time, that would mean roughly five cuts over the course of the year. In contrast, strategists at Bank of America are anticipating just 0.75 percentage points of cuts in 2024. Swiber attributes the difference to the risk baked into futures markets.

Traders are still accounting for the possibility that the U.S. economy may enter a recession in 2024, which could prompt swifter and larger rate cuts from the central bank. On the other hand, Swiber explains, “A more resilient economy means the Fed is going to have to hold rates higher for a longer period of time.” Bank of America recently revised its view that a recession was likely in 2024, and its experts currently expect a soft landing.

Traders are also more confident that “the inflation story is over,” she adds. As a result, predictions for the futures market are skewed toward a 2024 scenario in which the central bank isn’t as worried about keeping policy tight to bring down prices.

Other economists believe inflation might remain higher than the Fed wants next year, which would call for even fewer rate cuts.

The futures market can be wrong

Gillum points out that futures traders aren’t always right when predicting the path of interest rates.

“Markets were expecting about 2 percentage points of rate cuts only a couple of months ago,” he says. “We thought that was a bit aggressive.”

Trader predictions can change rapidly based on new economic data. Gillum explains that data they view as weaker than what the Fed is looking for might increase the number of cuts they predict, while stronger data could produce the opposite result.

What would prompt Fed rate cuts in 2024?

Morningstar’s senior U.S. economist Preston Caldwell anticipates roughly 3 percentage points of cuts between February 2024 and the end of 2025, which would mean five or more rate cuts would be possible during the first year.

Caldwell anticipates that inflation will drop below the Fed’s 2% target in the first quarter of 2024, which would “clear the way for the Fed to start cutting at their February meeting.” Adding slowing economic growth to the equation could prompt even more dramatic cuts, he says.

No one has a crystal ball for the economy, even when it seems like the data is moving in the right direction. Swiber says, “The issue is the Fed doesn’t know whether this disinflation we’ve seen is short-lived.”

In a closely watched speech in Jackson Hole, Wyoming, last week, Fed Chair Jerome Powell acknowledged as much.

“We can’t yet know the extent to which these lower readings will continue or where underlying inflation will settle over coming quarters,” he said, adding that there is “substantial further ground to cover to get back to price stability.”

If the Fed can get a handle on inflation, it will be able to deliver on the rate cuts the market is expecting, says Swiber. “But if inflation does prove stickier … the Fed is going to have to hold rates at a higher level for a longer period of time.”