Commentary: Tamp Down Those Fed Rate Cut Expectations
Much excitement was generated in December 2023 when the Federal Reserve decided NOT to raise the Effective Federal Funds Rate while “penciling in” moderate rate cuts in 2024. Based on this, the markets have priced in five interest rate cuts beginning in spring 2024. The year-end, hoped-for rate would then be 4.6%.
John Beuerlein, chief economist at the Pohlad Companies (parent company of commercial real estate company Northmarq), responded to this optimism with two words: Be reasonable. “There was nothing in the minutes of the Fed’s (December) meeting to suggest that the Fed is close to starting to cut rates or that it plans to cut rates as much as markets are currently expecting,” Beuerlein stated in his January economic commentary.
Beuerlein discussed signs that a knife might not be taken to the EFFR as much as the market might be thinking.
The “Real” Rate
We generally see the effective rate when the Federal Reserve raises or lowers its rate. There is also the real federal funds rate, which is the effective rate minus 12-month core inflation based on the Personal Consumption Expenditures (PCE) index. Beuerlein said that the current real Fed Funds rate is at a “restrictive” 2.7%. Beuerlein explained that if the 2024 projections are accurate, the real Fed Funds rate will be 2.2%, or 4.6% – 2.4% inflation, a move he called “only slightly less restrictive” than the current rate of 2.7%.
Balance Sheet Reduction
The Fed has attempted to slow down the economy by boosting its EFFR. It’s also working to reduce its balance sheet, an action it started in late 2022. The Fed had injected plentiful reserves into the banking system during the pandemic shutdown and economic fallout. But the rise of inflation halted that process, and the Fed continues to shed its holdings to “withdraw the liquidity it added during the coronavirus pandemic crisis,” according to Fed Chair Jerome Powell in November 2023.
The Fed is continuing to reduce that balance sheet to the tune of $95 billion a month, meaning “another policy tool that tightens liquidity,” Beuerlein said.
The Economy is Slowing – But Not Enough
Beuerlein pointed out that personal incomes and spending increased slightly in November 2023 (0.4% and 0.2%, respectively), while the personal saving rate was 4.1%, below the pre-pandemic levels of 8%. Banks are tightening lending standards. Meanwhile, the leading economic indicators declined for the 20th straight month, coming from “consumer expectations, manufacturing new orders, internal rates and building permits,” Beuerlein said.
But when it comes to jobs, demand remains greater than supply, even with a softening labor market. Job openings declined in November, as did hiring, while temporary jobs fell, typically a sign of a slowing labor market. Still, unemployment remained at 3.7%.
Understanding the Reality
Beuerlein explained that interest rates likely have peaked. By the same token, the rate-cut optimism is unwarranted, at least right now. “The Fed appears willing to keep rates elevated until they see a more substantial slowdown in the economy and sustained easing of inflationary pressures,” he added.
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