A year ago, the idea that the Federal Reserve would cut interest rates was mere speculation. And Jerome Powell emphasized that cutting rates was not an option as inflation remained in slippery territories. Today, however, such an idea of cutting rates has become an expectation, and investors have started to adjust their behavior to such eventualities.
In their latest economic projections released in December 2023, a majority of FOMC officials penciled in three quarter-point rate cuts for 2024. This suggests a decrease in the target range for the federal funds rate from the current 5.25%-5.5% to around 4.6% by the end of the year. Financial markets, on the other hand, anticipate more aggressive cuts compared to the FOMC's forecast, pricing in up to 1.5 percentage points in reductions throughout 2024.
The expected rate cuts are driven by moderating economic growth and easing inflation. Hiring and economic activity have slowed gradually in 2023, and while inflation remains above the Fed's 2% target, it has shown signs of decline. There's uncertainty around the exact timing of the first rate cut. While some analysts anticipate it as early as March, others expect it later in the year based on clearer evidence of an economic slowdown.
In an interview on Bloomberg Business News, James Gorman, the executive chairman and CEO of Morgan Stanley, expressed his confidence that rates will go down. In fact, he is expecting the “4-4-4” trio to happen, which stands for 4% inflation, 4% interest rates, and 4% unemployment. He stated that inflation is currently at 3%, interest rates around 5%, and unemployment at 3%. According to Gorman’s 4-4-4 trio, unemployment is supposed to rise while interest rates are supposed to be cut, which will leave inflation in the middle, at 4%. The rise in unemployment is expected to mitigate demand, according to Gorman.
A major concern is the possibility of a recession in 2024. By proactively cutting rates, the Fed hopes to head off a recession by mitigating the negative effects of a slowing economy and preventing a deeper downturn.
While cutting rates is expected to stimulate economic growth, there are certain risks and consequences to expect once they are cut. Since cutting interest rates is expected to boost consumer spending, an increase in consumer spending will certainly rekindle inflation. If the economy rebounds more strongly than expected, rate cuts could reignite inflationary pressures, forcing the Fed to reverse course and raise rates again. Moreover, cutting rates can potentially lead to an inflation of asset prices like stocks and housing, potentially creating unsustainable bubbles that could burst later. And lastly, a lower federal funds rate can make it cheaper for the government to borrow, potentially leading to higher budget deficits and debt levels.
We don’t know exactly when and by how much will the Fed cuts interest rates but it is a highly anticipated move by investors. Once rates are cut, we will have to see how the market reacts.