The United States economy outperformed expectations in 2023, and economic activity in the first quarter of 2024 signals continued solid economic growth. That backdrop coupled with a very strong stock market and continued elevated wage inflation are calling into question whether the Federal Reserve will cut interest rates this year.
The Fed will cut interest rates.
Fed Chairman Jerome Powell in his Wednesday testimony before the House Financial Services Committee explained that the first rate cuts, which were expected this month, will come later than anticipated. The market now sees the first cut coming in June or July. Because economic growth is more resilient than expected and because wage inflation remains somewhat elevated, the Fed will likely only reduce rates by about 0.5% from the current level of around 5.38%. The market is too optimistic. It sees rate cuts of 0.75%. The neutral interest rate, the rate that neither stimulates the economy nor restricts economic activity, is an interest rate of 1% to 2% above the current rate of inflation. Inflation is running somewhere around 2.8% on an annual basis. And on a six-month basis, inflation is rising at a rate of 2.1%.
With interest rates at 5.38%, monetary policy is restrictive. Policy is reducing economic growth. To ensure that nothing breaks in the economy, the Fed will begin the slow process of reducing rates sometime this summer. It is important to remember that monetary policy affects the economy with a long and variable lag. Even after one or two rate cuts of 0.25% each, policy will be restrictive with the effects of slower growth and lower inflation. The most probable course of action is one cut in June or July and another cut before the November elections. Under that scenario, the interest rate would be around 4.75%, 2 percentage points above the current rate of inflation. At that level, the Fed would be taking out insurance against something breaking but also continuing to put downward pressure on inflation.
Over the coming months, more data will confirm the economy is slowing and that inflation is continuing to fall. The manufacturing sector has been in recession for 16 consecutive months. Mortgage rates are very elevated, and the residential real estate market is soft. The Fed Bank of New York released data this week showing that low-income households are being squeezed hard by elevated rates for vehicle loans and by rising rates on credit card debt. Delinquencies and defaults are rising.
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Earlier this week, the Institute for Supply Management’s survey of the services sector of the economy, which accounts for 70% of economic activity, showed that growth in the services sector is slowing. Importantly, data this week from the ADP employment survey showed that wage inflation is growing at the slowest pace since August 2021. The stress in the commercial real estate market is well known. In 2025, about $1.5 trillion in debt in the commercial real estate market is set to mature.
Maintaining restrictive monetary policy could set off a contagion of bank failures among the thousands of small banks across the U.S. The Fed wants to avoid a repeat of the fiasco of the Silicon Valley Bank failure. The Fed will cut rates to ensure that maturing commercial real estate debt can be refinanced without causing contagion in the banking sector. The Fed will cut interest rates this year and will achieve a soft economic landing.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note.