Drew Peterson, CFA, CIPM®, Corporate Bond Research Analyst and Macro Strategist
Why Cut Fed Funds At All?
After months of discussions about how deeply the FOMC would cut rates in 2024, nothing speaks to the rapid shift in market sentiment better than the number of questions we’ve fielded recently about why the Fed should cut rates at all this year. Growth remains strong despite a Fed Funds Rate (“FFR”) that’s higher than any time since the dot-com era; the market is belatedly realizing that in a “soft landing” scenario, rate cuts aren’t actually all that pressing. So, why cut? This is a reasonable question, and a big part of the reason we came into the year expecting two to three rate cuts in 2024 rather than the market’s seven. We do believe rate cuts are coming, however; the key to understanding why has to do with the relationship between the Fed Funds rate and inflation.
The purpose of hiking rates is to drive down aggregate demand by making it more expensive to borrow, which in turn should reduce inflation. If borrowing costs less than the rate at which prices are expected to increase, it probably makes sense; if borrowing costs more than anticipated price increases, it likely doesn’t. It’s logical, then, to think less about the “nominal” or absolute level of rates, than the “real” rate, or how much it exceeds or falls short of inflation. While the nominal rate only changes when the Fed decides to change it, the real rate also changes with inflation, and as inflation falls then the real rate increases. Nominal rates have been on hold since the Fed last hiked in late July to 5.33%. Real rates, however, relative to Core PCE inflation, have more than doubled from 1.14% to 2.48% in that time. If inflation continues to fall, which we expect it will, then the Fed risks becoming a victim of their own success. At 2% inflation, an unchanged Fed rate would push real rates up to 3.33%. This will further tighten monetary conditions and could begin to jeopardize the soft landing the Fed has carefully engineered. The Fed will likely need to cut rates merely to maintain policy in real terms.
How Far Will The Fed Cut?
Looking at the December 2023 Summary of Economic Projections “dot plot,” the Fed still shows a long-term median forecast of 2% inflation with a 2.5% Fed Funds Rate. This implies a “neutral” real rate of 0.50%. Economists believe the neutral rate changes over time, and while 0.50% has been the prevailing estimate in the post-Great Financial Crisis era, this was closer to 1.5-2.0% in the ‘90s, and the post-GFC may be an anomaly. Sure enough, the individual dots in the “dot plot” show a growing upwards skew, with seven of the 18 voting members expecting rates to settle higher than 2.5%, and the highest dot at 3.75%, a significant change since the start of 2023. The ’90s were a period of above-trendline productivity growth, and heightened productivity today is a popular theory for why growth has held up as well as it has at current rates, so this shift is plausible. If nothing else, the fact that we’re not flirting with recession with a Fed Funds rate of 5.25-5.50% and six-month trailing inflation at the Fed’s target gives weight to the idea that the neutral rate may have risen.
Without a good way to directly measure the real neutral FFR, we expect the FOMC to find it iteratively, slowly lowering rates and watching how the economy responds. We expect this process to last years and would not be surprised if in 2026 we find the Fed on hold at 3-3.5% with 2% inflation, consistent with a neutral rate 0.50-1.00% higher than today’s estimate.
So, we still see compelling reasons for the Fed to begin cutting rates in the second half of 2024 even with 2% inflation and strong growth; falling inflation is itself making policy more restrictive with time, when considering rates from a real and not nominal standpoint. We think that at some point the Fed could shift their language to talk about real rates to explicitly recognize this, and that rate cuts would then be construed as a way of maintaining a given level of policy, rather than providing accommodation. However, we also believe there’s a reasonable chance this cutting cycle may end at a higher level than the markets expect.
This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience.
"Bank of America provides monthly updates on state tax revenue trends. In the Bank’s latest publication it noted that median sales tax collections in July are pointing to a 0.4% decline, which would be the second consecutive drop .."
"It is often said that predicting market direction correctly is much easier than timing. We concur with that sentiment, and one only needs to point to the fact that a year ago Appleton highlighted the risk of holding short-term bonds despite attractive front-end yields. Those yields are still appealing, although with Fed Funds rate cuts likely on the near-term horizon it’s time to revisit the case for adding duration..."
"A common refrain when discussing the Federal Reserve’s ongoing fight to quell inflation is “the last mile is the hardest.” On one hand, progress so far has come faster than many had anticipated, with both headline and core inflation falling below 4% before the end of 2023. This was largely due to volatile non-core food and energy prices, however, and core goods, where supply chain normalization has allowed transitory-after-all price pressures to quickly fade..."
Economic & Market Commentary
03.12.2024
The Case for 2024 Rate Cuts: Growth Is No Reason Not to Cut
Drew Peterson, CFA, CIPM®, Corporate Bond Research Analyst and Macro Strategist
Why Cut Fed Funds At All?
After months of discussions about how deeply the FOMC would cut rates in 2024, nothing speaks to the rapid shift in market sentiment better than the number of questions we’ve fielded recently about why the Fed should cut rates at all this year. Growth remains strong despite a Fed Funds Rate (“FFR”) that’s higher than any time since the dot-com era; the market is belatedly realizing that in a “soft landing” scenario, rate cuts aren’t actually all that pressing. So, why cut? This is a reasonable question, and a big part of the reason we came into the year expecting two to three rate cuts in 2024 rather than the market’s seven. We do believe rate cuts are coming, however; the key to understanding why has to do with the relationship between the Fed Funds rate and inflation.
The purpose of hiking rates is to drive down aggregate demand by making it more expensive to borrow, which in turn should reduce inflation. If borrowing costs less than the rate at which prices are expected to increase, it probably makes sense; if borrowing costs more than anticipated price increases, it likely doesn’t. It’s logical, then, to think less about the “nominal” or absolute level of rates, than the “real” rate, or how much it exceeds or falls short of inflation. While the nominal rate only changes when the Fed decides to change it, the real rate also changes with inflation, and as inflation falls then the real rate increases. Nominal rates have been on hold since the Fed last hiked in late July to 5.33%. Real rates, however, relative to Core PCE inflation, have more than doubled from 1.14% to 2.48% in that time. If inflation continues to fall, which we expect it will, then the Fed risks becoming a victim of their own success. At 2% inflation, an unchanged Fed rate would push real rates up to 3.33%. This will further tighten monetary conditions and could begin to jeopardize the soft landing the Fed has carefully engineered. The Fed will likely need to cut rates merely to maintain policy in real terms.
How Far Will The Fed Cut?
Looking at the December 2023 Summary of Economic Projections “dot plot,” the Fed still shows a long-term median forecast of 2% inflation with a 2.5% Fed Funds Rate. This implies a “neutral” real rate of 0.50%. Economists believe the neutral rate changes over time, and while 0.50% has been the prevailing estimate in the post-Great Financial Crisis era, this was closer to 1.5-2.0% in the ‘90s, and the post-GFC may be an anomaly. Sure enough, the individual dots in the “dot plot” show a growing upwards skew, with seven of the 18 voting members expecting rates to settle higher than 2.5%, and the highest dot at 3.75%, a significant change since the start of 2023. The ’90s were a period of above-trendline productivity growth, and heightened productivity today is a popular theory for why growth has held up as well as it has at current rates, so this shift is plausible. If nothing else, the fact that we’re not flirting with recession with a Fed Funds rate of 5.25-5.50% and six-month trailing inflation at the Fed’s target gives weight to the idea that the neutral rate may have risen.
Without a good way to directly measure the real neutral FFR, we expect the FOMC to find it iteratively, slowly lowering rates and watching how the economy responds. We expect this process to last years and would not be surprised if in 2026 we find the Fed on hold at 3-3.5% with 2% inflation, consistent with a neutral rate 0.50-1.00% higher than today’s estimate.
So, we still see compelling reasons for the Fed to begin cutting rates in the second half of 2024 even with 2% inflation and strong growth; falling inflation is itself making policy more restrictive with time, when considering rates from a real and not nominal standpoint. We think that at some point the Fed could shift their language to talk about real rates to explicitly recognize this, and that rate cuts would then be construed as a way of maintaining a given level of policy, rather than providing accommodation. However, we also believe there’s a reasonable chance this cutting cycle may end at a higher level than the markets expect.
This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience.
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