(Bloomberg) — The most important question facing the economy and financial markets next year is not whether the Federal Reserve will cut interest rates. this is the reason.
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With inflation down significantly from multi-decade highs last year, interest rate cuts in 2024 look increasingly likely. After holding policy steady for a third straight meeting this week, Federal Reserve Chairman Jerome Powell and his colleagues are expected to use a “dot chart” to forecast interest rate cuts in 2024 — though perhaps nowhere near the number that investors and economists expect.
If the central bank cuts interest rates simultaneously with slowing inflation, this is good news for the economy and investors. This would mean that the Fed is on the cusp of achieving an elusive soft landing in which inflation falls to pre-pandemic levels without the economy suffering a downturn.
But if the Fed is cutting interest rates because the economy is deteriorating significantly, at risk of recession or in a recession, that’s a different story. This would indicate that unemployment is trending up significantly and that corporate profits will take a hit as demand declines.
“You want to cut interest rates because the economy has slowed and inflation has slowed, not because the economy is in recession,” said Diane Swonk, chief economist at KPMG LLP.
The motivation for cutting interest rates by the Fed has implications for the number of cuts that will be made. If the economy is in recession or at risk of recession, officials are likely to ease policy quickly and significantly, economists said. Smaller, slower cuts are likely if there is not a deep pullback.
President Joe Biden has a lot at stake in how Chairman Jerome Powell handles the policy pivot. With voters already dissatisfied with Biden’s handling of the economy due to rising costs of living, the president will face greater headwinds to winning another term in November if the United States slides into recession.
There was little sign of contraction on the horizon in the November jobs report released on Friday. The unemployment rate fell to 3.7% from 3.9% in October. Payroll gains remained strong.
Read more: Fed rate cut glut eases after jobs data, boosting US yields
Money market traders lowered their estimates for interest rate cuts in the wake of stronger-than-expected jobs data. They now see less than a 50% chance that the first rate cut will occur in March, and are betting that the Fed will cut rates by just over a percentage point during 2024. Earlier this month, traders saw a roughly 60% chance To start facilitating. In March, cuts of about five percentage points are scheduled for the whole of 2024.
Current market prices are becoming more in line with economists’ expectations. Fed watchers polled by Bloomberg last week expect the central bank to cut interest rates by 100 basis points next year, with the first quarter-point cut occurring in June.
More than two-thirds of economists surveyed expect the economy to avoid a recession in 2024, and nearly three-quarters say the initial interest rate cut will come in response to lower inflation, rather than because the economy is contracting.
The poll indicated that the central bank, which is concerned about inflation, will be more conservative in predicting interest rate cuts than the markets when it releases the summary of economic expectations this week. Powell and Co. are expected to expect rate cuts of just half a percentage point next year in a dot chart released after their meeting, according to the Dec. 1-6 survey of 49 economists.
“We expect the dot chart to avoid signaling cuts in the first half,” said Brett Ryan, chief US economist at Deutsche Bank.
What does Bloomberg Intelligence say…
“Markets that were priced in for deep cuts in early 2024 could be in for a shock next week if the Federal Reserve reiterates that it will keep interest rates at their peak next year.”
-Ira F. Jersey and Will Hoffman, BI Strategists
For the full memo, click here.
Powell told students at Spelman College in Atlanta on Dec. 1 that it would be “premature” to speculate when the Fed might ease policy, and even leave open the option of raising interest rates further if needed to bring down inflation.
Read more: Powell backs off interest rate cut bets But markets are pulling back more aggressively
Over the last five cycles of credit tightening by the Fed, the average time from the last interest rate increase to the first cut was eight months, according to Joseph LaVorgna, chief economist at SMBC Nikko Securities America. With the Fed last raising interest rates in July, this puts the March rate cut into effect.
“A rate cut in March remains very likely with three more employment reports coming out between now and then,” LaVorgna said, with a deteriorating labor market and falling inflation prompting the Fed to act.
LaVorgna, who served in the White House under former President Donald Trump, said the November presidential election also leans on the margins of the Fed’s move earlier in the year to try to avoid the political glare.
LaVorgna believes that the central bank will cut interest rates by 125 basis points next year, with the clear possibility of more. He added that this would not be enough to prevent a recession, but it would limit the damage.
On the other hand, Michael Jaben, chief US economist at Bank of America, expects the economy to avoid deflation and for the Federal Reserve to cut interest rates by three-quarters of a percentage point in 2024, with the first step coming in June. He said that the decision to reduce interest rates would come in response to a decrease in price pressures, and not to a contraction in the economy.
“There are a number of headwinds and uncertainties in the inflation path,” said Lindsay Pegza, chief economist at Stifel Financial Corp. “The Fed can’t take its foot off the brake just yet.”
–With assistance from Sarina Yu and Liz Cabo McCormick.
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