Fed’s rate cut caution can’t spoil Wall Street party

And then there was only one. Despite encouraging inflation data, the US Federal Reserve Board now sees only a single rate cut this year, down from the three that were pencilled in at its last meeting in March.

At face value that median projection from the Fed’s Open Market Committee (FOMC) after their two-day meeting this week looks hawkish and should have disappointed Wall Street.

Instead, the US sharemarket posted another record and yields in the bond market fell back, indicating a greater level of optimism than the Fed’s projections might have suggested.

Fed chairman Jerome Powell said the central bank’s inflation forecasts had an element of conservatism to them.Credit: Bloomberg

That’s because the latest US inflation data was released just hours before the Fed’s statement. It was a pleasant surprise, coming in lower than expected with the headline CPI flat-lining in May, relative to April.

The more closely watched month-on-month “core” inflation rate (which excludes volatile food and energy prices) was a fraction less than 0.2 per cent, below the 0.3 per cent expected by the markets. That’s the slowest growth rate for US inflation since April 2021.

Having surprised everyone, including the Fed, in the first three months of the year, the inflation rate does seem to be edging down.

Whether that news was factored into the Fed’s projections – usually tabled ahead of its meetings – wasn’t made clear at the press conference held by its chair Jerome Powell, although, as he said, the data was encouraging, but it is only one month’s reading.

After the unexpected surge in inflation in the first quarter, the Fed wants to see more evidence that inflation is tracking firmly towards its target level of 2 per cent.

Powell said the committee’s projections of inflation rates at the end of the year – 20 basis point higher than the median projections in March – had an element of conservatism to them. The median core personal consumption expenditure rate (the Fed’s preferred measure of inflation) expected by the committee members has increased from the March projection of 2.6 per cent to 2.8 per cent.

The new median projection of a single 25 basis point cut to rates – produced by the Fed’s famous “dot plot” of the individual projections of the 19 members of the FOMC – could be misleading.

The later the Fed moves, if it moves at all this year, the closer it gets to the US elections in November

While seven members of the committee saw only one rate cut this year and four believe there will be none, eight think there will be two rate reductions, which is in line with what investors are pricing in. If the inflation rate continues to cool over the next few months, it is conceivable that there could be a cut in September and another one towards the tail end of the year.

As Powell said, with 15 of the 19 FOMC members looking for one or two cuts, either scenario is plausible.

As he also noted, while the median projection for this year has been wound back from three rate cuts to one, the committee members have lifted their expectations of the number of rate moves they expected to see next year from three to four.

In other words, while they think it could take a little longer to achieve their inflation targets than they thought in March, they do believe they are on the right trajectory. The easing cycle has been elongated but is still intact.

Circumstances could change. The March quarter blip in inflation might not have reflected a rekindling of inflation but the annual price-re-sets by American companies.

The housing-related costs that have influenced the elevated inflation rates operate with long lags, so it is conceivable that, with the economy slowing, unemployment rising and stresses emerging in the US property market, a major part of the inflation rate might start to trend in the right direction.

US consumer spending is also starting to weaken, with the indicators of household financial stress rising, particularly in low-income households.

The Fed is determined to produce a soft landing for the US economy. Not wanting to trigger a recession, it will inevitably respond to clear signs of a slowdown to protect the prospect of a “Goldilocks” outcome for the world’s largest economy.

At the start of this year, markets were pricing in up to six rate cuts. The March quarter reversal in the inflation trend seen in the latter half of last year saw those bets cut back to the three rate cuts the Fed itself thought were likely, and the timeline for the first rate reduction was pushed back to July at the earliest. Now it is one or two cuts, with a September move at the earliest.

The later the Fed moves, if it moves at all this year, the closer it gets to the US elections in November. President Joe Biden will be desperate for more good news on the inflation front between now and then, and will be hoping for at least one rate cut before November.

Powell has made it clear that the Fed will not be influenced by the political context this year, but will be driven by the economic data.

The Fed’s members, however, wouldn’t be human if they weren’t conscious of the sensitivities of their decisions in an election year. The more distance they can put between any rate action and the election on November 5, the less divisive and politicised their decisions will be.

Their meeting in September will be the last before the election, so if there’s going to be a pre-election move on rates, that’s the most likely moment.

The markets seemed to respond more to the inflation numbers than the Fed’s projections. Investors appear quite confident in both the outlook for the US economy and interest rates.

Even as the number of rate cuts factored into the markets has dwindled, investors have found different grounds for optimism while hanging onto a conviction – one buoyed by the latest inflation data – that there will still be more than one rate cut this year.

They may also have been encouraged by a sense that the global fight against the extreme inflation levels experienced in the aftermath of the pandemic is being won.

Last week, the Bank of Canada became the first major central bank to cut its policy rate. It was followed almost immediately by the European Central Bank.

While inflation rates are yet to hit their targeted levels in Canada and Europe, there was sufficient conviction that enough progress has been made to shift the balance of risks away from inflation to the impact of high interest rates on economic growth.

Despite the resilience of Australia’s inflation rate, with a flat-lining economy and household stress levels rising towards breaking point, the Reserve Bank will eventually come to a similar conclusion.

The Fed is potentially only another two or three data points away from the point the Canadians and Europeans have reached - which, if it were to happen, would come as a relief to central bankers elsewhere, given the level of influence that the Fed’s decisions have on their currencies, capital flows and interest rates.

Read more:

• Stephen Bartholomeusz: The US dollar is making a comeback at China’s expense
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• Ambrose Evans-Pritchard: Central banks face a horrible choice, warns the prophet of the Great Recession

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