The Federal Reserve increased rate in 2022 and 2023 as the central bank sought to contain surging inflation. Now, in 2024, with price pressures easing and the economy still strong, Fed officials are poised to bring rates down at a slower pace. Because the Fed’s benchmark rate influences lending costs for mortgages, cars, and credit cards, these slower-paced rate cuts may have significant implications for consumers and businesses.
But the fundamentals of these rate reductions are different than before. While the Fed generally lowers interest rates in response to recessions, the U.S. economy has remained resilient. At 3.9%, the unemployment rate is about the same as when the central bank began ratcheting up rates in March 2022.
Along with a January 2024 inflation rate that was higher than forecast–though lower than December 2023’s rate–the strength of the economy underlines the cautious approach many analysts have advised not just for an initial rate cut, but also for any future cuts. Fed officials have also repeatedly stressed their need to base any decisions on incoming economic data.
In its December 2023 summary of projections, the central bank signaled that it could cut rates three times in 2024. The present question for Fed watchers has been when the initial rate cut will happen.
For a while, futures traders were betting that the initial rate cut would come with the Fed monetary policy meeting in March 2024. But at the central bank’s January 2024 meeting and subsequently, Fed chair Jerome Powell suggested the initial rate cut would probably not take place in March.
Balancing Risks
The Fed began hiking rates aggressively in early 2022 in an effort to get inflation under control. In addition to these aggressive rate hikes, the Fed continued to withdraw liquidity from the system by allowing its balance sheet to shrink. Despite Fed rate hikes being on hold since their July 2023 meeting, the central bank has continued to shrink the balance sheet.
Fed officials are trying to balance two risks: One risk is the possibility of the economy crumpling under the weight of higher interest rates if they ease policy too slowly. The other risk is that, if they ease too much, too soon, inflation may become entrenched at a level above their 2% goal.
The Fed wants to see a sustained period of cooling price growth. They particularly want to see disinflation broaden beyond prices of goods to a deceleration in rents and services. The U.S. economy could be on a path to a soft landing—but a potential deceleration in prices could stall or even reverse that outcome. The Fed feels that it makes sense to be patient with the timing of rate cuts.
Economic data released in February and March 2024 has further underscored why Fed officials were skeptical of investors’ expectations of an imminent and sustained interval of rate cuts.
The jobs data for February was all over the place and January inflation (CPI & PPI) also came in above expectations. The takeaway is that the economy could still be on solid footing which might drive inflation higher again as consumers continue to spend their rapidly more lucrative paychecks.
An important reminder is that the Fed’s preferred inflation metric is the Personal Consumption Expenditure (PCE) price index rather than the Consumer Price Index (CPI). One big difference is that the weighting of the shelter component for the CPI is twice that of the PCE. Since a significant number of the public watches the CPI, it is tough to believe that the Fed will shun the index altogether.
On late February, we learned that the core PCE price index, the Fed’s preferred inflation gauge, had accelerated in January amid a surge in the costs of services like housing and finance, but the annual increase in inflation was the smallest in three years. In other words, the stakes for the upcoming Fed policy meetings aren’t nearly as high as they were in 2022 and 2023.
U.S. Economic Growth Accelerates
The United States’ gross domestic product increased at a 3.3% seasonally and inflation-adjusted rate in the fourth quarter, the Commerce Department said on February 22, 2024. This rate was down from the 4.9% rate in the third quarter but above forecasters’ expectations. This fourth-quarter increase was fueled by household and government spending. For 2023 as a whole, GDP grew 3.1%, up from less than 1% growth in 2022 and faster than the average for the five years preceding the pandemic. (This speedier economic growth, however, also makes any Fed pivot to interest rate cuts unlikely before June 2024.) For the first quarter 2024, the Fed is forecasting a slowdown of growth with estimates of between 2.1-2.5%.
For the fourth quarter of 2023, consumer spending, the bedrock of the U.S. economy, grew at a 2.8% annual rate, only modestly slower than the prior quarter. The housing sector, which was battered by high interest rates in 2022 and early 2023, grew modestly for the second quarter in a row. Businesses stepped up their investment in equipment. Personal income rose faster than prices as the strong job market continued to benefit workers.
The U.S. economy continues to show remarkable resilience. The economies of the United Kingdom and Japan declined at the end of 2023, underlining the widening gulf between robust growth in the U.S. and more anemic conditions in the rest of the world.
The U.S. economy grew much faster than economists had expected at the start of 2023, while Europe was badly hit last year by high energy prices from the war in Ukraine and rising interest rates. Economists forecast the growth gap will narrow somewhat over the course of 2024, but still remain wide.
For the 20-country eurozone (Austria, Belgium, Croatia, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain), as in the United States, inflation is easing. The central banks in those nations may cut interest rates later in 2024 after hitting record-high rates due to the pandemic and Russia’s invasion of Ukraine.
China faces the most challenging outlook amid real-estate woes, deflation, and demographic headwinds. The Paris-based Organization for Economic Cooperation and Development, an intergovernmental policy institute of 37 nations with market-based economies, said in early February 2024 that it expects the U.S. economy to grow by 2.1% this year, while the group sees the United Kingdom’s economy growing by only 0.7% and Germany’s economy by just 0.3%.
Warning Signs
Still, there are indications that consumer spending and U.S. economic growth won’t be able to continue at such a rapid clip. Economists, expecting consumer outlays to cool, forecast growth to ease to under 1% in the second and third quarters of 2024.
The four biggest U.S. banks reported higher credit-card spending in 2023 compared with the previous year and noted that customers are taking longer to pay off balances. Consumers’ use of overall credit has risen by 9.3% over the last year, among the highest growth rates in the data over the last 20 years.
Delinquency rates are rising. The personal saving rate fell further in December 2023 to 3.7%; it rarely fell below 5% in the decade before the pandemic. High interest rates continue to ripple through the economy, and developments overseas—from the conflicts in the Middle East to the economic weakness in China—could have domestic consequences.
Other signs of a slowing, though not crashing, economy have emerged. Manufacturers reported a modest drop in production in recent months, and some large companies have announced layoffs. Businesses are uncertain of how much pricing power they retain after years of steady increases that have been absorbed by customers. For some food and snack companies, including the bellwether Conagra Brands, the volume of purchases has slowed; these firms are starting to cut prices on some items.
Businesses, so far, have been reluctant to lay off workers following severe pandemic-related labor shortages; but that can change quickly, as high rates boost business costs while dampening sales. Narrowing profit margins could prod more companies to cut employees to maintain earnings.
Economists see a 36% chance of recession this year, according to the average estimate of forecasters surveyed by the Philadelphia-based firm Wolters Kluwer for its “Blue Chip Economic Indicators.” That chance is down from the 61% odds being touted in May 2023, but is still historically high.
It’s important to note that while recession risks may be elevated, consumers are coming from a very strong financial position. The unemployed are finding jobs, while those who already had jobs are getting raises.
Similarly, business finances are healthy, as many corporations have locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing costs looms, elevated profit margins give corporations room to absorb higher costs. At this point, any downturn is unlikely to turn into an economic calamity given that the financial health of consumers and businesses remains very strong.
Conclusion: Wait for the Cuts
There is every reason to believe there will be a rate cut sometime this year. In December 2023, Fed officials as of December projected three quarter-point cuts over the course of the year. Many investors and analysts now expect an initial rate reduction in June.
Fed chair Powell, appearing before the House Financial Services Committee on March 6. 2024, said rate reductions will “likely be appropriate” later in the year, “if the economy evolves broadly as expected.” He noted that “there’s no evidence, there’s no reason to think, that the U.S. economy is in, or in some kind of short-term risk of, falling into recession.”
In his testimony, Powell told the House panel that rate cuts “really will depend on the path of the economy. Our focus is on maximum employment and price stability, and the incoming data as they affect the outlook, and those are the things we’ll be looking at.” Powell told the legislators that the Fed “would like to see more data that confirm and make us more confident that inflation is moving sustainably down to 2%” before reducing the policy rate.
“We expect inflation to come down, the economy to keep growing,” Powell said. “If that’s the case, it will be appropriate for interest rates to come down significantly over the coming years.” But continued progress on lowering inflation “is not assured,” Powell said, which keeps Fed officials from committing to any rate-cut timetable.
History tells us the Fed’s monetary actions affect the economy with a time lag that has been long and variable. The Fed’s current monetary cycle was one of the most aggressive we have witnessed in many decades. Although the Fed dropped its tightening bias, it is also in no rush to start lowering rates in the interest of allowing more time for the long, variable lags associated with monetary policy and its economic impact. Overall, though, the aggregate indexes are not yet convincing the Fed that its 2% target can be reached, and then sustained, just yet.
Bowen Asset Management expects the central bank to keep monetary policy tight, which means tight financial conditions (e.g., higher interest rates, tighter lending standards, and lower stock valuations) will linger.
The full impact of the moves may still be in front of the economy. When the economy is growing at lower-than-trend, a shock of some sort could easily throw us into a recession. Unless something changes and the economy slows substantially or the labor market weakens noticeably, we do not expect a rate cut until June at the earliest.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a pretty rough couple of years, the long-run outlook for stocks remains positive.
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