Easing U.S. inflation and wage growth could reassure the Fed that its interest rate hiking campaign is finally working. The end of the Fed’s tightening cycle is potentially in sight, although the reasons for the Fed to steer towards a more accommodative policy may vary. For investors, the hope is that inflation durably returns to the Fed’s target, thereby forfeiting the need to keep rates elevated. Less positive would be rate hikes brought on by a recession or stagnant economic growth.

In the case where inflation declines quickly to the Fed’s 2% target on a sustained basis, policymakers could begin to consider that a Fed Funds Rate above 5% is too high. Afterall, their estimated “neutral rate” that would support economic production and employment with stable inflation is around 2.5%. Currently, the futures market expects the Fed to possibly begin to normalize its policy rate throughout the first half of 2024.

How quickly would the Fed cut rates?

The ongoing resilience in economic growth and the labour market may signal to the Fed that there is little urgency to cut rates. The Fed is likely cautious in easing policy to avoid the risks of further strengthening the economy and renewing inflationary pressures. Given how challenging it was to bring inflation under control in the post-pandemic period, the greater the likelihood that the Fed holds interest rates at higher levels for longer until there is solid evidence that inflation is heading towards their target. The opposite would be expected to occur in periods of recession, where the Fed has generally responded with rapid rate cuts. And in periods of stagnant economic growth, policymakers have opted for modest rate cuts in the form of consecutive cuts of 25bps (0.25%). In today’s context, with inflation seemingly hitting some friction on its way down from 3%, rate cuts are likely to be implemented slowly.

The last time this happened...

The last time the Fed implemented rate cuts to bring the Fed funds rate towards their estimated “neutral rate” was in 1995. Goldman Sachs currently forecasts a 25 bps rate cut in Q2 2024. By then, they expect both inflation measures of PCE and CPI to have fallen to or below 3.0% y/y and wage growth to have dropped to ~4.0% y/y. These estimates are aligned with the Fed’s Summary of Economic Projections and the conditions seen during the 1995 rate cuts. (see table below)

Overall, while futures markets and some research firms are pricing in rate cuts by the first half of 2024, the likelihood of a Fed pivot currently seems unlikely. With inflation still running above target and the economy proving more resilient than expected, the Fed will likely face no urgency to cut rates in the near term. That said, if the Fed opts to cut rates in 2024, it would likely be at a slow pace as it mitigates risks of further strengthening the economy and reaccelerating price growth. At this juncture, we advise clients to review with their advisor and identify the factors to watch within the CPI and PCE calculation that will have the greatest influence on bringing inflation to the Fed’s target.