With inflation pressures showing signs of easing, the Federal Reserve appears increasingly likely to shift gears and begin cutting interest rates through next summer. As the once-dominant threat of rising prices begins to fade, investors are recalibrating their expectations, betting that the Fed will pivot to support a slowing economy. This potential shift could have significant implications for everything from equity valuations to bond yields and currency dynamics. Here’s what traders should watch as the Fed signals a potential easing cycle on the horizon.
The Market’s Expectations for the Fed
Wall Street is increasingly aligning with the notion that the Fed could reduce its benchmark short-term rate from its current 24-year high of 5.25%-5.5% to as low as 3% by July of next year. Some economists, like Luke Tilley of Wilmington Trust, predict even steeper cuts, potentially down to 2.5% in 2025.
The first rate cut is expected to be announced at the conclusion of the Fed’s two-day policy meeting in Washington. Following that, traders are pricing in a sequence of rate cuts at each of the next seven Fed meetings, extending at least until mid-2025.
The primary driver behind the Fed’s pivot is the combination of a significant slowdown in inflation and a weakening labor market. The current inflation rate has eased to 2.5%, close to the Fed’s long-term goal of 2% and a dramatic decline from a peak of 7.1% in mid-2022, as measured by the Fed’s preferred PCE price index. Meanwhile, hiring has slowed, and the unemployment rate has risen to a three-year high of 4.2%.
The Dot Plot and Future Guidance
Next week’s meeting will also provide new insights into the Fed’s projections for inflation, economic growth, interest rates, and unemployment. However, the most closely watched aspect will be the updated “dot plot,” which outlines the Fed’s anticipated path for interest rates.
Back in June, the Fed projected just one rate cut in 2024 and four in 2025. Since then, economic conditions have shifted dramatically. Inflation has cooled, and the labor market has softened considerably, with hiring slowing to its lowest level since the pandemic.
Given this backdrop, the Fed is now more concerned about the state of employment than inflation. Under its dual mandate, the Fed must balance low inflation with maximum employment, and it appears the balance is tilting towards the latter. Tilley suggests that these concerns make a smaller initial cut more likely.
Market expectations have consequently shifted toward a series of rate cuts through the end of next summer, with at least three cuts anticipated in 2024 and four more in 2025.
The Debate Over Cut Size: How Far, How Fast?
Traditionally, the Fed prefers to move interest rates in small increments unless faced with a crisis. Dan North, Senior Economist at Allianz Trade North America, echoes this sentiment, arguing that the Fed is likely to proceed cautiously with 25-basis-point cuts. “The economy is holding up OK,” he says, suggesting that a larger cut might “send a message of panic” and unsettle markets.
On the other hand, some economists argue that the size of the initial cut will depend largely on how much the Fed perceives weakness in the labor market. While most Fed officials believe the job market is cooling in line with their expectations, there is growing unease. Fed Chair Jerome Powell recently underscored this concern in a speech, stating that the Fed is committed to keeping unemployment low.
Economists at Citibank predict that the Fed’s concerns are significant enough to justify several half-point cuts over the coming year.
Economic Impact of Lower Rates
Lower interest rates are expected to inject much-needed momentum into the U.S. economy. High borrowing costs have weighed heavily on various sectors, from housing to manufacturing. Reduced rates could help boost home sales, encourage auto purchases, and support business investment.
While the Fed aggressively raised rates in 2022 and 2023 to combat inflation—the highest levels since the early 2000s—there is a growing consensus that inflation could hit the Fed’s target of 2% as early as January, a year earlier than previously anticipated.
However, there are still questions about whether the Fed can maintain that target. As Eugenio Aleman, Chief Economist of Raymond James, puts it, “There will be a window next year when inflation will drop below 2%.”
Risks and Open Questions
Despite optimism, several factors could complicate the Fed’s path. Ongoing government spending, housing costs, and potential supply chain disruptions remain risks to achieving sustained low inflation.
Reducing interest rates will make mortgages cheaper and could reignite housing demand, potentially driving up home prices again. While the Fed is unlikely to focus on housing in the short term, inflationary pressures from this sector could become a concern down the line.
Ultimately, the Fed’s primary goal is to engineer a “soft landing”—bringing inflation down without triggering a recession. While rate cuts will help, the effects will take time. As North notes, “It usually takes three to five quarters for lower borrowing costs to have a full impact on the economy.”
Key Takeaways for Traders and Investors:
- The Fed is poised to begin a series of rate cuts, likely starting with a modest reduction next week.
- Wall Street expects rates to drop to around 3% by mid-2025, with a possibility of deeper cuts depending on economic conditions.
- Investors should be cautious of market volatility as the Fed navigates the delicate balance between low inflation and high employment.
- The Fed’s ability to achieve a soft landing remains uncertain, with multiple economic factors still in play.
