Dollars and Sense

The Federal Reserve is just under three weeks away from delivering its first interest rate cut in four years. While at times it felt like the day would never come, inflation has finally stabilized close to the 2% target alongside a noticeable cooling in the labor market. The Fed’s focus has now pivoted away from just fighting inflation, to striking the right balance on its dual mandate to ensure the economic landing remains a soft one. This is the stage where markets typically get nervous on whether the Fed has got the timing right, evidenced by recent bouts of financial volatility (Chart  1). The emphasis will be on downside misses in the data given that the Fed’s policy rate is sitting at a lofty level of 5.50%. And with that, we can expect to see pricing jump around between a Fed that needs to act urgently to one that can move in a measured way. But in all circumstances, one prediction will hold firm: the Fed will cut interest rates in September, kicking off a prolonged cycle. This is not a one-and-done deal.

From inflation fears to recession 

For much of 2024, Fed members were content maintaining the policy rate at 5.50%, and at one point, a rate cut occurring at any point this year looked elusive. The first quarter reflected reaccelerating inflation and a job market that defied gravity. The Fed steadily pushed out the timing and scope from three cuts before year-end, to a mere single move in their June Summary of Economic Projections. But the tables finally turned. Inflation reversed course over the summer, pushing core PCE inflation to a comforting 2.6% year-on-year (y/y). And the trend is their friend, with the three-month annualized pace holding at the low-2% level. Even near-term consumer expectations for inflation have re-anchored to long-term levels (Chart 2). Cementing this was the July employment report, which not only showed a big drop-off in hiring, but caused the unemployment rate to resurrect the oft-referenced recession predictor, the Sahm Rule. 

To set the record straight, we are not believers in the Sahm Rule as a hard-and-fast recession predictor, but it’s a reminder of the magnitude of the downshift in labor market fundamentals. The data mining exercise is compromised when the economy reflects a surge in population and labor force growth. As Chart 3 captures, the rise in the unemployment rate within this cycle compared to the past is reflective of bulging entrants into the workforce, and not a surge in exits and layoffs. It needs to be coupled with more reliable variables used by the recession dating committee at the NBER that capture the broad status of the U.S. economy (see Table 1). This swath of recession indicators argue that the economy is still in cool-mode and not cratering. In other words, the Fed absolutely needs to start cutting interest rates to start the journey back to a neutral setting, but there’s not a compelling argument to act aggressively.

Table 1: Recession Indicators

Table 1 shows colored values for various indicators. For ones that are growing, it is highlighted green. For those close to zero, it is yellow. 

Source: TD Economics. *Real income less transfers. **Real sales. ***Occurrences where the indicator went negative without a corresponding recession.

	Current Reading	Trend	Recessions Captured	False Warnings***
Household Survey	0.0%	↓	100%	2
Payroll Survey	1.6%	↓	100%	0
Personal Income*	1.8%	-	78%	2
Industrial Production	-0.2%	-	100%	7
Manufacturing Sales**	1.9%	↑	100%	2

How low should they go?

Once on board with the need for cuts, the next logical question is: how much? Economists apply general rules as guidance, with the updated version of the Taylor Rule being the most cited. This incorporates the state of the labor market and how far inflation is from its 2% target. Taking all this together, we find that monetary policy is between 100 to 200 basis points above where it should be given the state of the economy.   The significance of this gap is why market participants react so hard to negative economic data. Any data point that signals the Fed may be behind the curve (like the weak July jobs report) is magnified when considering how much the Fed would need to cut to return to neutral levels. 

We’d be remiss if we didn’t mention that there are many assumptions that go into measuring the appropriate level of the policy rate. We already highlighted the requirement to make assumptions on the state of the jobs market and to take a view of future inflation, but what is arguably hardest to measure is the real neutral interest rate – which is that goldilocks interest rate that keeps the economy in perfect balance of not too hot, and not too cold. This rate is impossible to know in the moment, causing wide-ranging estimates. By some accounts, the dispersion is more than 100 bps. No wonder there is so much debate on just how restrictive interest rates really are!

What we do know is that the longer the Fed waits, the more restrictive the policy rate becomes. This is because inflation has continued to ease. It has been over a year since the Fed policy rate hit the current level of 5.50% and, over that time, inflation has fallen by 1.6 percentage points. Even though the Fed hasn’t made any further adjustments, the real rate of interest (adjusted for inflation) keeps increasing (Chart 4). This is one of the strongest arguments for the Fed to commence the rate cut cycle and proceed in a well-telegraphed, steady pattern thereafter. Otherwise, it risks having to move in larger, more disruptive, steps of 50 basis points or more if domestic demand finally capitulates under the weight. 

We anticipate the policy rate to reach 4.75% by year-end and 3.00% by the end of next year. Importantly, this path will require a change of position from the Fed, which had only penciled in one rate cut this year and four 25 bps cuts in 2025. That is more than 100 bps above our current thinking. 

However, the Fed hasn’t tipped its hand yet on this pivotal piece that will ultimately guide market expectations over the course of the rate-cut cycle. That will come on September 18th, at the FOMC meeting that will produce the famous “dot plot”. So far, we only know from Chair Powell’s speech at Jackson Hole that there’s a clear intent to cut, and that the pace will be set by the data. Basically, he signaled full optionality to speed-up the pace of cuts should economic fundamentals deteriorate more than they anticipate.