The Fed, in the FOMC meet, decided to cut the base rate by 50bps, the federal funds rate now stands at 4.75% to 5%. The Fed’s move was largely on expected lines. This marks a change in the monetary policy stance of the world’s reserve currency. The reverberations of the current action coupled with the trajectory of feds funds rate would be felt over a period of time across markets.
For the rationale behind the rate cut, the FOMC statement read as, “Job gains have slowed, and the unemployment rate has moved up but remains low. Inflation has made further progress toward the Committee’s 2 percent objective but remains somewhat elevated”. The gains achieved in inflation through the series of rate hikes initiated from Mar’22 till Jul’23 and its impact on employment numbers have led Fed now bringing back its focus on its dual mandate. The recalibration of policy was gradually getting necessitated to avoid a hard landing. A deeper cut may have been an exercise to send the message to the markets, that the Fed is cognizant of the growth risks and is ready to support it. On the flip side, a deeper cut may also be construed as an indication of higher risks to growth going ahead.
The two key monitorables of the Fed have largely moved in line with the targets. The Fed’s projections too indicate an easing scenario for inflation and employment. The headline inflation is expected to ease to 2.3% for 2024 as per the latest projections, as against the previous projection of 2.6%; the target of 2% inflation is indicated to be achieved in 2026. The unemployment rate is projected to be 4.4% for 2024, as compared to 4% indicated earlier. The revisions in key economic variables’ forecasts indicate that the Fed believes it is behind the curve and kept rates higher for longer than necessary.
The Fed’s projections and the dot plot, on the base rate front, imply that there may be further rate cuts to the tune of 50 bps for 2024, 100 bps for 2025 and 50 bps for 2026, taking the neutral rate in the range of 2.75% to 3%. The future rate cuts are expected to be more calibrated and in 25 bps steps, unless substantial risks to growth surface that require fresh salvo. The key risk to rate cut projections is inflation. The policy has turned dovish when, apart from employment numbers, other economic indicators such as GDP and consumer spending remain fairly robust.
We believe that easing of interest rates is a positive for capital markets as the Fed is firmly supporting growth to avoid a build-up of recessionary scenario in the economy. A soft landing is also important from the perspective that there may not be compulsions of any financial engineering such as zero interest rate policy. The extreme responses to get out of recession sow the seeds for the next one. The asset class disruptions by way of hunt for yield have unintended consequences and bubble formations. If the current rate cycle progresses and concludes as per the Fed’s projections, it would mark a culmination of the experiments with zero interest rate policy that was initiated as a response to GFC 2008.
