Rate Cuts Are Coming, But Timing Remains Uncertain

Summary

With a resilient economy and sticky inflation, expect policymakers to choose caution over speed.
Despite recent inflation data surprising to the upside and breaking from the end-of-year trend, we have long held that the path to target inflation would not be smooth.
The central bank’s ability to orchestrate a soft landing (avoid recession while coming close to target inflation) has been in question.

By Olumide Owolabi

With a resilient economy and sticky inflation, expect policymakers to choose caution over speed.

Coming into the year, the consensus believed that, outside of Japan, developed-market central bankers were done with interest rate hikes and poised for immediate rate cuts on the back of accelerated disinflation.

However, recent inflation overshoots, the healthy labor market and generally robust economic data (reflecting unique strengths within the U.S.) has turned policymakers less dovish and pushed back the expected start of the cutting cycle.

This has contributed to wild swings in market pricing, but we believe that cuts are on the way, based on a few factors:

Gradual disinflation. Despite recent inflation data surprising to the upside and breaking from the end-of-year trend, we have long held that the path to target inflation would not be smooth, due to elevated intra-sector dispersion, extreme (but now improving) supply channel dislocation, seasonality and slow normalization of core services pricing, driven by consumer consumption. We maintain our belief that moderation of inflationary pressures should continue, but probably at a slow pace.

Fed mandate on labor. Although the rebalancing of the labor market has been slower than expected, as normalization is currently driven by shrinking vacancies rather than the typical increase in joblessness, we do not expect this to hinder interest rate cuts if inflation continues to moderate, considering that part of the Federal Reserve’s mandate is to “promote maximum employment.”

Rare opportunity for ‘immaculate’ outcome. The central bank’s ability to orchestrate a soft landing (avoid recession while coming close to target inflation) has been in question, but as the odds improve, we think policymakers could deliver proactive “insurance cuts” to engineer that elusive policy prize.

Looking back at this hiking cycle, central bankers have guided the market using different themes at different times, from “sufficiently restrictive” to “higher-for-longer” and now, “data-dependent.”

We believe that the current data-dependent theme implies a monetary policy phase where the destination is somewhat clear (policy rates should normalize from restrictive levels) but the path remains ambiguous - as such, caution and patience will be key for policymakers.

So far in 2024, investors have reduced 2024 rate pricing by nearly three to four cuts in aggregate when compared to the start of the year, shifting toward central bank projections.

We expect pricing of policy rates to continue to move around with each economic data release as policymakers cautiously wait for inflation and the economy to move into better balance before taking action.

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