Markets See Spring Rate Cuts, The Fed Isn’t There Yet

The debt markets expect the U.S. Federal Reserve to cut interest rates in spring 2024. In contrast, policymakers believe its premature to discuss rate cuts until they see further evidence of cooling inflation. As of October, annual headline Consumer Price Index Inflation is running at 3.2% compared to the Fed’s 2% target. Fed officials are also signaling that a rate increase remains an option. However, both markets and the Fed ultimately agree that short-term interest rates will move lower in 2024.

Market Expectations

For the near term, current expectations are that rates will hold steady at the Fed’s upcoming December meeting. Beyond that, both debt and equity markets currently signal that interest rate hikes are over. The CME’s FedWatch Tool currently gives a 90% chance that interest rate cuts occur no later than May 2024, with a 60% possibility of a March cut.

U.S. equity markets too have rallied strongly from late October lows, likely in part on expectations that interest rates are at peak levels.

Recent Fed Comments Downplay Rate Cuts

However, policymakers continue to emphasize that it’s too early to discuss rate cuts. At a speech at Spelman College on December 1, Fed Chair Jerome Powell said, “The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.”

Fed Governor Michelle Bowman struck a similar tone at a speech on November 28, saying, “At our last meeting, I supported the FOMC’s decision to hold the target range for the federal funds rate at the current level as we continue to assess incoming information and its implications for the outlook. But my baseline economic outlook continues to expect that we will need to increase the federal funds rate further to keep policy sufficiently restrictive to bring inflation down to our 2 percent target in a timely way. However, monetary policy is not on a preset course, and I will continue to closely watch the incoming data as I assess the implications for the economic outlook and the appropriate path of monetary policy.”

However, despite these statements, when Fed officials last updated their Summary of Economic Projections on September 20, 2023 the majority of officials did forecast the Fed funds rate moving lower by the end of 2024.

Upcoming Data

It may be that the market is more confident in cooling inflation from upcoming inflation reports than the Fed. The markets implicitly forecast upcoming economic events, whereas the Fed can wait for the data before reacting to any news.

Nowcasts of inflation from the Cleveland Fed show headline inflation is expected to come down in upcoming reports. However, core CPI inflation, which strips out food and energy is expected to remain close to 4% for the remainder of 2023.

Recession Risk

The other factor is recession risk in 2024. A recession would likely cause the Fed to cut rates and indicators such as the inverted yield curve imply a recession could be coming. The jobs market could also bring a recession warning if unemployment increases. For now, markets appear less concerned about recession fears, especially after strong Q3 economic growth. So for now, the markets appear to expect lower rates due to progress on inflation rather than recession fears.

Historical Analysis

Historically, once the Fed stops raising rates for a prolonged period, further rate increases are then unlikely and cuts are probable. The Fed last increased interest rates on July 26, 2023. However, the U.S. economy and especially the jobs market has performed better through this interest rate cycle than many others, so far. In addition there have been many unique aspects to the post-pandemic economic recovery that economists have not forecasted.

What’s Next?

There is broad agreement between the Fed and markets that we are close to, if not at, peak interest rates and that short-term rates will ultimately come down in 2024. However, for now, the markets see cuts coming earlier than Fed statements suggest.

If inflation cools further, then the Fed may indeed cut rates earlier in 2024. However, if the economy continues to run hot and if inflation remains stubbornly above the Fed’s 2% annual goal, then the Fed’s view may win out. Much depends on incoming inflation and jobs data, but the market is increasingly optimistic.