We have been forecasting two rate cuts for September and December, but as the market has already done, we acknowledge the risk is that they are delayed into next year. While the Fed has a dual mandate of price stability and maximising employment, a central bank needs to defend its inflation credibility, and it is difficult to justify rate cuts when inflation is above target and rising further away from it.
The Fed’s position in early 2022 was that inflation is transitory during a supply shock, and they needn’t raise rates. However, robust hiring, soaring wage growth, pent-up demand coming out of lockdowns and stimulus checks meant consumer spending jumped significantly and inflation spiralled higher. The Fed then had to play catch-up, hiking rates 525bp between March 2022 and July 2023.
Today, the labour market is in a far weaker position with job creation and real household disposable income stalling over the past six months. At the same time, confidence has been eroded by tariff worries and job security fears, so there isn’t the same demand impetus to fuel inflation. This should mean inflation is indeed “transitory” this time around.
Instead, we suspect that today’s energy shock risks being demand destructive, which ultimately leads to lower core inflation. If there was an equity market correction, then the demand destruction would be all the greater. Consequently, we continue to have a bias to lower Fed funds rates over the next 12-18 months.
While tax refunds are expected to be quite substantial this year (around $4000 on average versus $3200 last year) we would likely need to see a larger fiscal boost, such as stimulus checks, to generate enough demand that would entrench inflation pressures and trigger Federal Reserve rate hikes. Bond markets would undoubtedly take fright, in part due to concern over higher debt levels and in part due to inflation worries and this would ignite talk of highly damaging 1970s-style market dynamics. Hence, we see this as a low probability event.