Are We There Yet? Yes!…Rate Cut Assured Next Week…Will it be 25 or 50 bps? (50/50)…
Next week’s Fed meeting will open with the most highly telegraphed rate cut ever. The last two weeks of data provided the final “permission slip” for policy easing. The August jobs report indicated less jobs created in August than expected along with major revisions to previous months. The unemployment rate ticked down to 4.2%, but the “real” unemployment rate that adds in part timers unable to find full time work, workers earning less than a living wage, etc. jumped to 7.9%, the highest in 3 years. The weak employment numbers worry Fed officials as they have shifted their focus to employment rather than inflation. Last week’s release of the Fed’s “beige book” showed flat or declining economic growth. “Employers were more selective with their hires and less likely to expand their workforces, citing concerns about demand and an uncertain economic outlook.” The number of regions reporting declining growth jumped to 9 (up from 5 last month). Fed San Francisco President Mary Daly described businesses as “frugal” but not yet “dusting off their layoff manuals.” That’s the essence of the “Fed Fear Factor” that may push them to a 50 bp cut next week: big layoffs usually occur “all of a sudden” and rate cuts occur “too late” aka the dreaded “hard landing.” Inflation: This week’s CPI and PPI releases indicated cool inflation as CPI rose 0.2% month over month and 2.5% annually (smallest annual increase since Feb 2021). Core monthly ticked up to 0.3% (unexpected) but the chief factor was an increase in shelter prices. Shelter is a lagging indicator with wonky methodology. The “mainstream” number excluding shelter is below the Fed’s 2% target (see chart below).
With inflation seemingly under control (for now), the Fed is all systems go to cut. This week’s hotter than expected CPI core cooled expectations of a 50 bp rate cut…futures market probabilities of a large cut hovered in the 15% range mid-week. Sentiment shifted yesterday as influential analysts such as Jon Faust (recent senior adviser to Powell) and Bill Dudley (ex-Fed official) voiced support for a 50 bp cut – futures jumped to 50%. Big picture: today’s Fed rate of 5.30% is 200-250 bps above the so-called neutral rate (where the Fed thinks it will end up, a rate neither stimulative nor restrictive). The R* rate as its also known by is estimated to be about 2.75-3.25%. Most Fed officials and analysts expect a gradual easing of policy (that’s why the Fed very much wants to avoid a “hard landing” that forces them into large cuts out of desperation). Fitch rating agency expects 250 bps of cuts in 10 meetings, a classic “gradual step down” scenario: 75 bps in 2024 (3 meetings remain), 125 bps in 2025 and 50 bps in 2026 with equilibrium achieved in Spring 2026. But some feel that 100 bps in cuts is needed for 2024, so maybe starting with 50 bps is the right way to kick it off. With inflation running at about 2.2%, “real interest rates” are now 3.0% (the difference between the Fed cost of funds and inflation). Dropping real rates to 2.5% is still restrictive. The 10-year Treasury is dropped to a 52-week low of 3.60% this week, now at 3.65%. The 25 vs 50 question adds a layer of uncertainty to next week’s meeting (after all that telegraphing, we still don’t know everything). Will markets react negatively to a 25 bp cut as expectations are unfulfilled? Will Powell’s press conference sooth or roil markets? Stay tuned…
By David R. Pascale, Jr., Senior Vice President at George Smith Partners.