The Fed will not cut rates this year. Here’s why.

The Fed pivots unexpectedly to rate cuts

What a difference a few weeks can make.

For the most part of last year, the Fed pushed back against investors' growing expectations of imminent interest rate cuts. Even in December, Fed Chair Jerome Powell continued to maintain that discussing the timing of interest rate cuts was premature.

However, that all changed on 13 December 2023, when the Fed drastically shifted its stance. Breaking from its earlier position, the Fed announced that it is now contemplating loosening and had adjusted its projections to include three quarter-point cuts to interest rates in 2024, citing falling inflation as the key reason for the shift. Markets went even further – they are now pricing in an incredible six rate cuts for 2024, with the first cut coming in May.

We’re not so sure. We believe inflation is far from being brought to heel, and are hesitant to jump on the rate cut bandwagon for now. Our base case is for the Fed to hold rates this year.

We outline our rationale in this article.

Economic resilience keeps the inflation threat alive

To be sure, inflation has indeed been falling fast. The consumer price index (CPI) has declined from a pandemic-era peak of 9.1% in June 2022 to 3.4% in December 2023. If inflation continues to cool at this rate, it is just a matter of time before the Fed achieves the 2% target that will allow it to start cutting rates (or so the thinking goes).

But that’s a big if.

Even as inflation has been coming down steadily, the resilience of the US economy means the inflation threat remains well alive. Consider the latest GDP report. Recent data released by the Commerce Department revealed that the economy grew at an annualised pace of 3.3% in the final quarter last year – that’s well ahead of the consensus estimate of 2.0%.

Consumer spending, which accounts for more than two-thirds of economic activity, has been holding up well even as spending was expected to weaken in the face of higher interest rates. It is showing no signs of losing steam, with retail sales accelerating more than expected in December and consumer confidence rising in January to the highest level in two years. Despite a year of rising prices for everything, households still have 32% more in their bank accounts than they did before the pandemic (Chart 1). This large pile of savings will provide a cushion for the economy.

Chart 1: Households are still sitting on a large pile of savings

Importantly, the labour market continues to look robust. The US economy added 216,000 jobs in December, greatly surpassing market expectations and is nearly double the long-term growth in the labour force. The unemployment rate remains near record-low levels, while wage growth – at 4.1% year-on-year – is still too fast to be consistent with the Fed’s 2% inflation target. With about 1.4 job openings available for every unemployed person, the labour market is still relatively tight compared to pre-pandemic levels (Chart 2).

Chart 2: A still-significant gap between labour supply and available jobs

Besides, massive spending by the government, through policies such as the Inflation Reduction Act (IRA) and the CHIPS and Science Act, means the economy is unlikely to see a downturn anytime soon. At 7.5% of GDP, the budget deficit in FY2023 is on an unprecedented scale seen only during wartimes. In the first quarter of FY2024 (from 1 October 2023 to 31 December 2023), the government chalked up another deficit of USD 510 billion. At this rate, the deficit could total more than USD 2 trillion by the end of FY2024, higher than the USD 1.7 trillion deficit in FY2023. The lavish spending is likely to stimulate the economy and further boost inflation.

At this point, the US economy certainly does not need any support from rate cuts. In fact, cutting rates at a time when the economy is doing well could lead to a resurgence in inflation once again. Just ask Arthur Burns, the Fed Chair who presided over a long period of rampant inflation in the 1970s after failing to keep monetary policy tight enough for long enough to permanently quash inflation.

A prolonged Red Sea crisis could fuel the next inflation wave

If history is any indication, inflation never follows a linear pattern. It comes in waves with several peaks and troughs, as evidenced by the inflationary periods in the 1940s and 1970s, during which there were several unexpected inflationary surges (Chart 3).

Chart 3: Inflation comes in waves with several peaks and troughs

The current inflationary episode has also seen its fair share of unexpected events: from snarled supply chains, tight labour markets, generous fiscal stimulus, the Russia-Ukraine war, and the sudden surge in oil prices last year, investors have constantly been caught off guard at every turn. As such, the recent moderation in inflation does not, on its own, guarantee a continuous downward trend. While we’re not saying that a second inflationary wave is inevitable, there are good reasons to worry about one.

For clues on where the next inflationary driver will come from, look no further than the Middle East, where as many as ten countries are now caught up in fighting. These escalating tensions pose a fresh threat to inflation, particularly the repeated attacks by Houthi militants on cargo ships in the Red Sea that have forced shipping companies to avoid the Suez Canal and reroute their vessels around South Africa’s Cape of Good Hope.

The importance of the Suez Canal cannot be overstated. Not only does it handle approximately 12% of global cargo transportation and 30% of container trade, the canal’s location also makes it a key regional hub for shipping oil and other hydrocarbons, enabling the transfer of an estimated 7-10% of the world’s oil and 8% of liquefied natural gas. It would be reckless to ignore the risks emanating from a vital trade route that is critical to the flow of energy, commodities, consumer goods, and componentry from Asia and the Middle East to Europe.

Besides, disruptions at one trade route have ripple effects throughout the supply chain as rerouted ships can easily overwhelm alternative routes. Freight rates on shipping routes from China to US East Coast have already jumped 132% since October, while rates from China to US West Coast have similarly skyrocketed 131% over the same period.

While the US and UK have responded by forming an international task force to ensure the safe passage of commercial vessels through the Red Sea, the Houthi attacks have continued. Far from being extinguished, they have threatened more attacks instead. The threat does not look like it will end soon. Armed with drones and ballistic missiles, the Houthis are a highly sophisticated force that is unlikely to be bombed into submission. 

The economic impact is already being felt. The West Texas Intermediate (WTI) is up nearly 6% year-to-date (as of 31 January 2023), shipping costs have more than doubled since October (Chart 4), and there are increasingly lengthy transit delays for goods.

Chart 4: Shipping costs have more than doubled since October

No one knows how long the disruptions will last or how bad it will get. If the disruptions persist, it will certainly fuel another surge of global inflation, forcing the Fed to hold off on its widely expected interest rate cuts. It’s also worth noting that in an increasingly multipolar world, the potential for global geopolitics to disrupt maritime trade, which accounts for a whopping 80% of international trade by volume, is on the rise.

Consensus overwhelmingly tilted to rate cuts

Given the uncertainties surrounding inflation, it remains premature to declare its defeat. Many things could yet go wrong: the resilience of the economy could exert upward pressure on inflation, while supply chain disruptions due to a widening Middle East conflict could also cause inflation spikes. As such, we are hesitant to join the growing chorus of investors who are convinced that aggressive rate cuts this year are all but guaranteed.

In fact, the consensus is now overwhelmingly tilted towards aggressive rate cuts. Despite Jerome Powell’s attempts during the Fed’s first policy meeting of the year to push back the timing of rate cuts, indicating that the Fed wanted to see continued progress on inflation before lowering rates, investors continue to price in six rate cuts in 2024. With markets pricing in such a high probability of aggressive rate cuts, there's very little room for error. If inflation unexpectedly goes up, it is not inconceivable for the Fed to hold rates at its current level for a prolonged period.

Besides, market predictions on Fed policy have mostly been wrong ever since inflation began to surge in 2021. Investors have either underestimated the Fed’s willingness to raise rates or overestimated how quickly it will start cutting them. Now that the market is pricing in a rapid loosening of monetary policy, a healthy dose of caution is warranted.

Higher-for-longer rates are here to stay

It’s time for us to accept this new paradigm: the era of easy money that investors have grown so accustomed to over the years is over. Higher-for-longer rates are here to stay. Even if the Fed does cut rates this year, it is unlikely to be as aggressive as what investors are pricing in at this moment. Interest rates would still be far higher than they were before the tightening cycle began in March 2022.

While the current Fed funds rate of 5.25-5.50% is much higher than where it has been for most of the last 20 years, it is worth remembering that the interest rate landscape since the global financial crisis was more of an anomaly rather than the norm. Prior to the dotcom bubble, the Fed funds rate ranged from 3-8% in the 1990s, suggesting that the current 5.25-5.50% rate is relatively normal (Chart 5).

Given our expectation that inflation and interest rates will stay higher for longer, investors should consider investing in the following: : (1) opt for short duration bonds for fixed income; (2) invest in quality companies and commodity-related stocks for equities.

Chart 5: Rate landscape since the global financial crisis was an anomaly

Table 1: Recommended products to consider

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in the JPMorgan US Quality Factor ETF.