The Federal Reserve may be a bit late cutting interest rates, but it’s not yet behind the curve in forestalling a U.S. recession.
For all the wild financial swings and furious trading of the past week, markets have yet to price in a Fed monetary policy stance that would actively stimulate the economy at any point over the coming two-year cycle.
While that could highlight investors’ lingering concerns about sticky inflation, it more likely reflects their doubts that some deep recession is in fact brewing.
And what it indicates most clearly is that the Fed only has to lift its foot off the brake to keep the expansionary ride going.
Markets were clearly spooked by the surprisingly sharp rise in the U.S. jobless rate last month - and further aggravated by the Big Tech stock shakeout. As volatility spiked, markets have raced to price a series of deep Fed rate cuts over the months ahead.
Just one month ago, futures prices indicated that barely two quarter-point cuts were anticipated over the remainder of the year, but now they show expectations of twice that - some 115 basis points at last count on Tuesday.
Most notable among a series of hastily revised forecasts, U.S. investment bank JPMorgan now projects that we will see two half-point cuts in both September and November, followed by a quarter-point cut in December.
Not for the first time, this may seem a little overcaffienated. And it certainly reflects the market volatility present right now in a holiday-thinned August.
But what’s happened further out the curve is perhaps more instructive about what investors expect to see in the full easing cycle ahead.
There’s little doubt now the Fed will start cutting next month: its signaling about that was crystal clear at last week’s meeting. But where the cutting stops is less obvious.
Looking at futures and money market pricing on Monday, the so-called terminal rate over the next 18 months never got below 2.85%, even during the most extreme part of the day’s turbulence
That’s a long way down from the current policy mid-rate of 5.38%.
But it’s still above where Fed policymakers see the long-term ‘neutral’ rate - widely seen as their proxy for the fabled ‘R*’ rate that neither stimulates or reins in economic activity. That median long-run rate is currently 2.8% - after being pushed up 30 basis points by Fed officials this year.
So, if anxious money markets don’t think the Fed will be forced to go below that, then the slowdown ahead can’t be expected to be that bad - despite all the hand wringing of recent days.
At the very least, it suggests markets remain equivocal about recession and think the removal of policy ‘restriction’ may be enough by itself to hold the line.
MEAN REAL
Another way to look at it is to view the ‘real’ inflation-adjusted Fed policy rate, which is currently 2.5%. That’s the highest level in 17 years. It has risen steadily from zero since April 2023 as disinflation has set in.
If the Fed’s full easing cycle turned out to be the 250 bps suggested by markets this week - and consumer price inflation were to remain as high as 3% through that period - then the real policy rate would merely return to zero at its lowest.
Bear in mind that the average real policy rate over the past 15 years was -1.4%, so a reversion to zero is not suggesting the Fed is heading for anything like emergency mode.
All conjecture? The Fed has a busy six weeks ahead to clear it all up.
Fed officials speaking this week suggest they’re not too worried about recession yet but everything is still on the table policy-wise. They also insist that they will continue to have meeting-by-meeting assessments and that one month of data or market upheaval won’t change their minds unduly.
Perhaps cryptically, San Francisco Fed chief Mary Daly said the central bank “is prepared to do what the economy needs when we are clear what that is.”
Part of what set recession talk rumbling was the triggering last week of the so-called Sahm Rule, which posits that a 0.5 percentage point rise of the three-month average jobless rate over the low of the prior year typically presages recession.
But even the rule’s author, ex-Fed economist Claudia Sahm, downplayed the latest trigger due to pandemic and weather- related distortions still plaguing the jobs data.
And yet, with the labor market softening either way, the Fed still seems set for a September rate cut - a move that will also be accompanied by an update of policymakers projections, including that long-run neutral rate.
And before then, the Kansas City Fed’s annual Jackson Hole symposium takes place on Aug. 22-24 - where longer-term Fed thinking tends to get sketched out in more detail.
“It was a mistake that the Fed didn’t cut rates last week, but I don’t believe it will cause irreparable damage to the economy,” reckoned Invesco strategist Kristina Cooper. “This sell-off (in stocks) is a very emotional market reaction that is overestimating the potential for recession.”
And the rates market may not even be pricing in recession at all.
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