(Bloomberg) — The most important question facing the economy and financial markets next year isn't whether the Federal Reserve will cut interest rates. That is, why.
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With inflation falling dramatically from a decade-long peak last year, rate cuts in 2024 are becoming increasingly likely. After sticking to policy for the third straight day this week, Fed Chairman Jerome Powell and his colleagues are expected to use their “dot plot” to forecast interest rate cuts in 2024 – although probably not nearly as many as investors and economists expect.
If the central bank cuts interest rates while cooling inflation, that's good news for the economy and investors. This means the Fed is on the verge of an elusive soft landing in which inflation returns to pre-pandemic levels without causing the economy to suffer a downturn.
But if the Fed cuts rates because the economy is deteriorating dramatically, is facing a recession, or is in a recession, that's a different story. That would signal that unemployment will rise significantly and that corporate profits would fall as demand weakens.
“They want rate cuts because the economy has cooled and inflation has cooled, not because the economy is in recession,” said Diane Swonk, chief economist at KPMG LLP.
The motivation for Fed rate cuts impacts how many there will be. If the economy is in recession or at risk of recession, officials are likely to ease policy quickly and significantly, economists say. Smaller, slower cuts are likely unless there is a sharp downturn.
There's a lot at stake for President Joe Biden when it comes to how Chairman Jerome Powell handles the political transition. With voters already sour on Biden's handling of the economy due to rising costs of living, the president would face even greater headwinds to his continued term in November if the U.S. falls into a recession.
The story goes on
There was little sign of a decline in the November jobs report released Friday. Unemployment fell to 3.7% from 3.9% in October. Wage growth remained solid.
Read more: Fed rate cut exuberance fades after jobs data, boosting US yields
Money market traders reduced their rate cut estimates following stronger-than-expected jobs data. They now see less than a 50 percent chance that the first rate cut will come in March and are betting that the Fed will cut rates by just over a percentage point in 2024. Earlier this month, traders had seen about a 60 percent chance of easing starting in March and envisaging around five quarter-point cuts for all of 2024.
Current market prices are now more in line with economists' forecasts. Fed watchers surveyed by Bloomberg last week expect the central bank to cut interest rates by 100 basis points next year, with the first quarter-point cut coming in June.
More than two-thirds of economists surveyed expect the economy to avoid a recession in 2024, and nearly three-quarters say the first rate cut will be a response to easing inflation rather than due to an economic slowdown.
The inflation-wary central bank will be significantly more conservative in predicting interest rate cuts than markets when it releases its summary of economic forecasts this week, according to the survey. According to the Dec. 1-6 survey of 49 economists, Powell & Co. are expected to budget only half a percentage point of rate cuts next year in the scatter chart released after their meeting.
“We assume the dot chart suggests no cuts in the first half of the year,” said Brett Ryan, a senior U.S. economist at Deutsche Bank.
What Bloomberg Intelligence says…
“Rates markets, which have priced in deep cuts in early 2024, could be in for a shock next week when the Federal Reserve reiterates that it will keep interest rates at their peak well into next year.”
— Ira F. Jersey and Will Hoffman, BI strategists
For the full notice click here.
Powell told students at Spelman College in Atlanta on Dec. 1 that it was “premature” to speculate about when the Fed might ease monetary policy, even leaving open the option of raising interest rates further if necessary to curb inflation contain.
Read more: Powell pushes back on rate cut bets, but markets fight back harder
According to Joseph Lavorgna, chief economist at SMBC Nikko Securities America, the average time from the last rate hike to the first rate cut in the Fed's last five credit tightening cycles was eight months. Since the Fed last raised interest rates in July, a rate cut is imminent in March.
“A rate cut in March is still very likely with three jobs reports left before then,” Lavorgna said, with a deteriorating labor market and slowing inflation prompting the Fed to act.
The November presidential election also tends to see the Fed take steps early in the year to avoid political attention, said Lavorgna, who served in the White House under former President Donald Trump.
Lavorgna expects the central bank to cut interest rates by 125 basis points next year, with the distinct possibility of further cuts. That won't be enough to prevent a recession, but it will limit the damage, he added.
In contrast, Bank of America chief economist Michael Gapen expects the economy to avoid a downturn and that the Fed will cut interest rates by three-quarters of a percentage point in 2024, with the first step coming in June. The decision to cut rates was a response to easing price pressures rather than a shrinking economy, he said.
“There are a number of headwinds and uncertainties surrounding the trajectory of inflation,” said Lindsey Piegza, chief economist at Stifel Financial Corp. “The Fed can’t quite take its foot off the brake yet.”
– With support from Sarina Yoo and Liz Capo McCormick.
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