Given the uncertainty surrounding the "neutral" interest rate level, the Federal Reserve's aggressive rate-cutting cycle may rekindle inflation risks. In Schroders' view, the risk of underestimating the neutral rate is greater than that of overestimating it. This necessitates a more prudent easing pace than what the current dot plot anticipates. Consequently, the current expectation remains that the committee will cut rates by a quarter of a percentage point in March and June 2025, respectively, and then pause the rate-cutting pace to assess the effectiveness of the already implemented easing policies (a cumulative rate cut of one and a half percentage points). If inflation then remains controlled, this should pave the way for further moderate monetary policy easing in 2026.
When the Federal Reserve initiates a rate-cutting cycle with a half-percentage-point reduction, it typically garners investment market attention. The United States had previously taken the same measure in January 2001 and September 2007 (three to four months before the U.S. economy fell into recession), as well as in March 2020 at the onset of the global pandemic. Due to the appearance of such a move, the bank had assumed that the Federal Reserve would follow the mid-cycle adjustments of 1995, 1998, and 2019. In those three adjustments, a slowdown in economic growth (not recession) prompted the Federal Reserve to begin rate cuts with a conventional quarter-point reduction.
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Schroders stated that only the U.S. Federal Open Market Committee (FOMC) chose a more aggressive half-percentage-point reduction, aligning with the expectations of 91 out of the other 100 economists surveyed by the bank and institutions. Federal Reserve Chairman Powell attempted to position this as a "re-calibration" during the press conference, mentioning this point no less than nine times, while emphasizing the long and variable lags in the effects of monetary policy. This implies that, for the current stage of the economic cycle, interest rates are too tight, and the Federal Reserve also wishes to return to the neutral rate as soon as possible.
While Powell's logical rationale is understandable, it is believed that such an aggressive monetary easing pace is unnecessary. Neutrality is an imprecise concept; it is not a measurable number but a theoretical interest rate level that is neither too tight nor too loose, allowing economic growth and inflation to return to a stable and predictable path. However, if an aggressive rate-cutting cycle occurs, and the U.S. economy proves more resilient than policymakers expect, U.S. monetary policy may ultimately become too loose or fall below the neutral level, reigniting inflationary embers.
Federal Reserve Governor Bowman also seems to share the same concerns, as she supported a quarter-point rate cut at the September interest rate meeting. She believes that the U.S. labor market remains close to full employment, even with recent signs of weakness affected by data calculation and immigration issues. Although inflation has clearly eased, she thinks it is too early to declare victory, so it is best to proceed at an appropriate pace to avoid unnecessarily stimulating demand.
However, Bowman is clearly in the minority. The FOMC members' "dot plot" forecast for the interest rate at the end of 2024 suggests an additional half-percentage-point rate cut on top of the current 5.00-4.75% federal funds rate range by the end of the year. Although this move is somewhat excessive, it is best not to go against the Federal Reserve. Therefore, it is expected that the Federal Reserve will cut rates by a quarter of a percentage point in November and December, whereas previously, it was only expected to cut rates in December. Coupled with the significant rate cut in September, this is an additional half-percentage-point rate cut compared to previous expectations, prompting the bank to raise its already consensus-beating 2025 growth forecast of 2.1%.
Schroders' risk for interest rate forecasts is downward. It is currently unclear whether the investment market has prompted the Federal Reserve to cut rates by half a percentage point in September; even so, the committee should not make this approach a habit. The latest forecast includes an "aggressive rate-cutting" scenario: in this case, concerns about economic growth prospects persuade the committee to implement the aggressive rate cuts anticipated by the market. The bank believes that this will ultimately lead to a re-acceleration of inflation and force the committee to start raising interest rates again.
