It Is Time – the other side of the mountain

In the words of one of the greatest supporting roles of all-time, this being Rafiki from the Lion King – It is time, (finally).

We understand this is a bit tongue and cheek but the amount of false starts in 2024, we think it sums up what traders have been experiencing. So, we have reached the other side of the mountain. The cuts are coming. The question now is by how much and how often. It is this question that we traders now need to address. 

First let’s look to Thursday’s September Federal Open Market Committee (FOMC) meeting. Current market pricing has the FOMC reducing the target range for the federal funds rate by 43 basis points, which puts the probability of a 50-basis point cut in the range of 65 to 70 per cent. This would bring the Federal Funds rate to 4.75 per cent to 5.00 per cent. The consensus from the economic community also points to a 50-basis point cut. However, the number of 50-basis point worth of cuts versus 25-basis point worth of cuts sits at 24 to 20 suggesting a more conservative view than the headline figure. 

Our two cents on this using the recent communications from the Fed and barring more severe economic deterioration, we think the Committee will likely opt for a series of 25 basis point cuts going forward including Thursday’s meeting.

What is not disputed is whatever they do on Thursday it’s likely to be the beginning of a series of rate reductions aimed at recalibrating monetary policy to better align with evolving economic conditions – which as we have discussed over the last few weeks is pretty gloomy. 

So who is right on Thursday’s meeting and what else can we traders take out of the current FOMC environment.

All the Talk – nothing is linear

The future trajectory of US monetary policy will depend on several changing factors, labour market dynamics being the biggest one. 

Take Federal Reserve Governor Christopher Waller’s recent remarks that emphasised the uncertainty surrounding the pace and total amount of rate cuts. He highlighted that these decisions will be data-driven and measured. While he believes “it is time” to begin cutting rates, the start should be a modest reduction as the data, while suggesting things are poor, are not flashing red. 

He also remains cautious about making any definitive projections regarding the pace of future cuts. This is important for us – the market is basically pricing in an almost linear decline in rates through to August next year.

Waller thinks it isn’t that clear cut – as he distinguishes between “softening” which it currently is doing in the labour market and a “deterioration” which would be out and out capitulation. This suggests that aggressive action (such as 50 basis point rate cuts) would only be considered if there is a notable and sustained decline in employment.

Now if we take Waller’s comments and marry them with New York Fed President John Williams as a clearer picture of the board’s thinking emerges. Williams uses the term “dial down” to describe the gradual reduction of rates and stressed that policy adjustments should move “to a more neutral setting over time.” 

This is not the language of a Board considering hard and fast action on monetary policy. Rather one that is looking for a steady, deliberate process. 

Which brings us to one of the more dovish players on the Board San Francisco Fed President Mary Daly’s – have a look at these words when asked about rate cuts: “regular cadence” in adjustments, this aligns with Waller and Williams remarks and suggest the expectation of a methodical approach rather than abrupt shifts is the better trading view.

Now there are some caveats to what we have just presented. Waller did not entirely rule out the possibility of larger cuts particularly if there was a sharp labour market contraction. The current economic outlook does not suggest such a drastic deterioration in the labour market, but Waller’s flexibility indicates the Fed’s readiness to act decisively if conditions worsen, so again not linear and the hard and fast option may still materialise.

The Man himself: A Clear Path Forward

This is all well and good but really what does the man himself think? Gauging his plethora of talks, speeches, firesides and everything else that’s in the public domain Fed Chair Jerome Powell looks to be leaning into the expectation that rate cuts once started will be pretty consistent until it hits target. He has, like the others, emphasised that the path forward remains data dependent.

What we think he will say going forward is that while inflation has not yet been fully tamed, the current stance of monetary policy remains restrictive enough to continue exerting downward pressure on inflation. At the same time, expect him to point out that the Fed has room to lower rates while still working towards its dual mandate of maximum employment and stable prices. Specifically, Powell may highlight the need to prevent further slowing in the labour market, and that recalibrating rates downward is crucial to avoiding an unnecessary shortfall in employment.

He is also likely to frame the upcoming rate cuts as a measured approach to bringing inflation back to target while safeguarding the labour market and broader economy.

Crystal balls – How far down the mountain

So where does all this leave us? The consensus for the FOMC’s Dot Plot Projections reflect a path of gradual rate cuts. That same consensus is forecasting that the Committee will project rates approaching 3.00 per cent by the end of 2025, reflecting a moderate easing cycle designed to balance the need for inflation control with concerns about growth and employment. 

Based on all of the above, expect the median policy outlook to include three 25 basis point rate cuts in 2024, followed by five additional cuts in 2025, and one final cut in 2026 to bring us down the mountain. 

This would bring the terminal federal funds rate to a range of 3.00 per cent to 3.25 per cent, although don’t be surprised if the forecast ends with the rate slightly lower, in the 2.75 per cent to 3.00per cent range, aligning with the Fed’s longer-term rate expectations.

So it is time – tomorrow’s FOMC meeting is likely to mark the beginning of a rate-cutting cycle, with gradual easing expected through 2024 and beyond. Inflation remains a key focus but it is increasingly shifting its attention to preventing an excessive slowdown in the labour market, signalling a clear path towards further rate cuts while maintaining a balanced approach to managing economic risks.