Macro Signposts | 24 September 2024
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The Fed's Bold Move and What It Signals for Future Policy
Last week's decision by the U.S. Federal Open Market Committee (FOMC) to cut interest rates by 50 basis points (bps) marked a significant shift in monetary policy: the first pivot toward easing since 2019, and the first time since 2007 that such a cut was greater than 25 bps. This bold move, accompanied by a downward revision of forward rate projections, signals a desire to normalize policy more rapidly than previously anticipated. The median FOMC participant now expects the fed funds rate to end 2025 in a range of 3.25%-3.5%, which is 150 basis points below its current level and edging closer to estimates of neutral policy.
Federal Reserve Chair Jerome Powell and other FOMC members have said this bold move reflects the changing balance of risks to the Fed's dual mandate (price stability and maximum employment). Notably, the Fed's updated economic projections suggest policymakers see inflation risks as largely balanced, but unemployment risks as tilted to the upside. (Learn more in our article: "Starting With a Bang: Fed Cuts Policy Rate.")
This shift in the distribution of risks opens the door for further downward adjustments to Fed officials' rate path outlook. Some commentators characterized last week's 50-bp cut as "insurance" against an economic downturn. However, true insurance in that sense would entail lowering the policy rate not only to neutral, but to a slightly accommodative level. Based on the individual rate level projections in the updated dot plot, it appears that a few officials already anticipate moving to accommodative policy in 2026 and 2027 - that is, a rate level under their long-run neutral estimate. However, the median path isn't there yet, and while we aren't forecasting a recession, we don't think it would take much in the way of negative labor market data to move the Fed more firmly in that direction. Powell has indicated the Fed would prefer not to see any further increase in the unemployment rate.
The changing distribution of risks around inflation and unemployment should be a call to action for investors to review portfolio allocations of high quality government bonds. The Fed's larger first rate cut was a good reminder that elevated cash rates are usually fleeting, and that shifting from cash to core tends to outperform during interest rate cutting cycles. The Fed is pulling its policy levers mindfully in an effort to engineer a soft landing, but the simple acknowledgment of the shifting balance of risks strengthens the case for a bond allocation to help hedge portfolios against an economic downturn. And at current levels, bonds offer an attractive yield cushion, too.
Why fifty? Unpacking the Fed's thinking
Prior to last week's Fed meeting, we noted a distinct probability of a 50-bp cut; however, we (like many observers) believed the easing cycle would begin with a 25-bp cut. We thought that cutting 25 bps while also announcing large downward revisions to the rate path projections would be the Fed's way of balancing potentially conflicting signals: the need to bring monetary policy back to neutral relatively quickly, while recognizing that macro data, overall, still appear to reflect a relatively solid U.S. economy. Such a move would have also acknowledged the uncertainty surrounding the level of the fed funds rate that is consistent with neutral policy - neither restrictive nor stimulative - and indicated that the FOMC is prepared to "feel" its way toward this level over time.
But that isn't what happened. Instead, the FOMC cut rates by 50 bps while signaling that more front-loaded cuts could be coming. In addition, Fed officials offered an assessment of the distribution of risks that implies they believe those risks may be tilted toward even faster rate cuts and a lower destination than the new projections imply. These bold moves suggest that officials are increasingly uncomfortable with the current stance of monetary policy in light of recent labor market developments - and that they are willing to acknowledge, however indirectly, that discomfort.
The recent rise in the U.S. unemployment rate, which has triggered the so-called Sahm rule (details in our 7 August 2024 Macro Signposts), has gotten a lot of attention because historically such a shift has been a strong real-time indicator of an economy in recession. However, we've argued that the immigration surge in 2023 has lifted labor supply, accounting for around half the rise in the unemployment rate, which suggests the economy is not currently in recession. Nevertheless, labor markets, and labor demand in particular, have slowed and are still slowing. As Powell emphasized during the press conference, the economy is reaching the point where further declines in labor demand are likely to affect employment, not just job openings.
Where is neutral?
Given this context, there is a clear rationale behind not only getting to neutral but also providing some level of accommodation. However, the policy rate level consistent with neutral is highly uncertain.
As Powell noted, valid arguments suggest that the neutral real rate may be higher now than it was after the global financial crisis (GFC). This shift is primarily attributed to increased government debt levels and the absence of a post-GFC focus on balance sheet repair among consumers and corporations. Yet, the extent of the increase remains uncertain, as the long-term demographic trends and wealth disparities that have weighed on the neutral policy rate over the past 50 years have not receded. Current estimates place the neutral real rate within a range of 0% to 1% - consistent with PIMCO's longstanding New Neutral range - with a potential inclination toward the higher end of that spectrum.
The unique factors characterizing the post-pandemic period have further complicated the assessment of neutral policy levels. Despite the Fed's rate hikes, the U.S. economy has demonstrated remarkable resilience, driven by robust consumption growth. Higher interest rates have successfully hampered investment, particularly in the residential sector, which began to stagnate in 2022 but is now showing signs of reacceleration. However, resilient consumption growth has been the key driver of the U.S.'s economic outperformance.
The same factors that rendered consumption growth less sensitive to rising rates during the Fed's tightening cycle - such as a large pool of low-rate, long-duration mortgages, a surge in immigration, and elevated post-pandemic real wealth balances - may also contribute to reduced sensitivity to interest rate cuts today.
Investment implications
Consequently, the FOMC faces the challenge of navigating its path to neutral by cutting rates and assessing the real-time impact on the economy while managing downside risks to labor markets. Policymakers appear poised to front-load a series of cuts. We believe a sequence of 25-bp cuts per meeting until March 2025, totaling 150 bps, is a reasonable base case for an economy showing signs of slowing.
In the markets, short-dated futures contracts based on fed funds futures contracts are priced for this faster approach to neutral, and in fact, markets are priced for a somewhat steeper decline in the policy rate through 2025 than the median Fed projection would suggest. We think this reflects markets pricing in some risk that deteriorating economic conditions may warrant a faster pace of cuts than the FOMC currently projects. However, further out the interest rate curve, with nominal intermediate rates nearing 4% and real yields around 1.8% (we use 5-year, 5-year-forward rates for reference), we see a substantial potential yield cushion relative to long-term neutral estimates.
Furthermore, Powell's remarks suggest that bonds may serve as a valuable hedge against downside macroeconomic scenarios. The recent loss of momentum in the U.S. labor market is one of those risks. Another is the downside risk to global growth - especially in regions such as China, with potential spillback into the U.S.
The Fed's turning point in September may mark an opportune time for investors to reassess their bond allocations. Fixed income can offer both diversification benefits and return potential. Yields remain attractive in both nominal and inflation-adjusted terms, and the bond rally looks poised to continue as the Fed continues to ease policy.
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All investments cnntain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.
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