Can the Fed really cut six times?

Fed funds futures are pricing in as many as six 25-basis-point cuts in 2024, which would take the policy rate from 5.4 per cent to below 4.0 per cent. Markets have, in other words, bought the story of a perfect landing. The Federal Reserve's own history suggests the story has a hole in it.

Inflation is slowing, slowly

The latest data give the doves something but not everything. Consumer prices rose 3.1 per cent in the year to November, down from more than 9 per cent at the peak in the summer of 2022, but core prices, which strip out food and energy, were still up 4 per cent and rose 0.3 per cent in the month alone. Unemployment fell to 3.7 per cent in November, and the economy grew at an annualised rate of around 5 per cent in the third quarter. Those are hardly the numbers of an economy that needs rescuing.

Employers added 199,000 jobs in November, a pace comfortably above what a growing population needs to hold unemployment steady. Some of that gain came from striking car workers and actors returning to work, so the underlying figure was softer. Still, a labour market that is cooling gently gives the Fed no urgent reason to move. Average hourly earnings are also still rising faster than a 2 per cent inflation target would comfortably allow, which keeps services prices under pressure.

How the market got here

The pricing moved fast. At the start of November futures implied only modest easing next year. Then came a benign reading on October inflation, a Treasury decision to sell less long-dated debt than feared, and a speech on 28 November in which Christopher Waller, one of the committee's hawks, sketched the conditions for a cut. Jerome Powell pushed back on 1 December, saying it was too early to talk of easing, and the market rallied anyway.

The market has been here before this year. In January, and again after Silicon Valley Bank failed in March, futures priced rate cuts for the second half of 2023. The Fed instead raised rates in May and July and has held since. Traders who bet then that the committee would blink lost money, and the same reaction function sits in the same people now.

Six cuts need a crisis

Central banks have usually cut six times in a single year only during deep recessions or banking panics. If the US economy grows by 2.5 per cent and unemployment stays near 3.8 per cent, the Fed has no reason to ease quickly. Cutting into a growing economy would risk reviving inflation and undoing months of progress.

The Fed's record bears this out. In 2001, as the dotcom bust turned into recession, it cut eleven times. In 2008 it took rates from 4.25 per cent to nearly zero as the banking system buckled. When it has eased without a recession, in 1995-96, in 1998 after the collapse of Long-Term Capital Management and again in 2019, it stopped after three quarter-point cuts each time. A soft landing has historically meant 75 basis points of easing, and the market is pricing twice that.

What the futures really say

There is a fair defence of the market. Futures prices are an average across outcomes, so a curve showing six cuts may combine a real chance of recession, with many more cuts, and a larger chance of a soft landing with only a few. Real rates also argue for some easing: with inflation falling and the policy rate unchanged, policy tightens automatically, a point Christopher Waller made last month. Neither argument gets to six cuts in a healthy economy, but together they explain why the pricing is less mad than it looks.

The doves have one more point. In September the committee's median estimate of the neutral policy rate in the long run was 2.5 per cent, so even six cuts would leave policy well above neutral and still restrictive. The Fed is also shrinking its balance sheet by up to $95 billion a month, a second form of tightening that continues whatever happens to the policy rate. On that view, cutting to around 4 per cent merely eases the pressure without releasing it. The weakness of the argument is that neutral is estimated with wide error, and officials know it.

Who loses if the Fed does less

The first losers from a slower path would be holders of two-year Treasuries, whose yields have fallen furthest on the expectation of early cuts. Rate-sensitive shares, such as small companies with floating-rate debt, have rallied on the same bet and would give some of it back. The dollar, which weakened as markets priced American cuts ahead of those elsewhere, could firm. Borrowers who have put off refinancing in the hope of a quick fall in rates would face a longer wait. Savers would be the quiet beneficiaries, since money-market funds and bank deposits tied to the policy rate would keep paying above 5 per cent for longer than the curve now assumes.

What would change the call

The Fed publishes new projections when its meeting ends on Wednesday, and the median dot for 2024 will show how far the committee is willing to follow the market. September's projections pencilled in a policy rate of 5.1 per cent at the end of next year, far above what futures now imply. A recession signal, such as a jump in jobless claims or a string of weak payroll reports, would make six cuts plausible, while steady growth and sticky services inflation would make them fanciful. The December jobs report in early January and the December inflation figures a week or so later are the first tests of which path the economy is on.

Markets cannot have both six cuts and healthy growth. If growth holds up, the Fed will probably deliver fewer cuts than futures imply, and investors who bet on the full six are likely to be disappointed. The likeliest outcome is three or four cuts starting around the middle of next year, which would leave two-year Treasury yields higher by the summer than today's pricing assumes.