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We wish everyone a happy and healthy holiday season and new year. Please note Macro Signposts will pause for two weeks, resuming in January with highlights from our upcoming Cyclical Outlook.
Central Bank Cuts: Lessons From History
Interest rate cuts are likely top of mind for many investors since Federal Reserve Chair Jerome Powell told reporters after last week's Federal Open Market Committee (FOMC) meeting that participants had discussed their outlook for rate cuts. New York Fed President John C. Williams and others have since tried to clarify Powell's message, but short-dated fed funds futures contracts continue to imply a roughly 70% chance that the Fed will cut in March 2024.
In past publications we've argued that central bankers across developed markets, not just the Fed, will likely lag in easing policy, for fear of inflation reaccelerating, as it did in the 1970s under then-Fed Chair Arthur Burns. Powell has said on multiple occasions that the Fed will not quit until the job is done; he has repeatedly emphasized that the risks of the Fed doing too little to fight inflation outweigh the risks of doing too much. And while significant progress has been made on inflation, there are still reasons to be concerned that the last mile may prove "sticky" as wages and inflation in key services components continue to move sideways.
Estimating just how much central bankers might lag is more of an art than a science, however, and may very well come down to Powell himself. The median policy rate path in the Fed's latest Summary of Economic Projections (SEP), released last week, roughly implies a pace of 25-basis-point rate cuts at every other meeting, though it depends on when the Fed starts cutting. An initial cut in May or June would be consistent with the 75 basis points (bps) of cuts currently projected through the end of 2024. Nevertheless, our interpretation of last week's press conference is that cuts could start as early as March.
This may seem like a large change in communication versus the September FOMC meeting, when the FOMC was readying the markets for further hikes. However, our analysis of historical cutting cycles and the economic milestones reached when central banks have started to cut rates suggests that September, not December, may have been the anomaly.
History lesson
Fed officials and other central bankers often cite various versions of Taylor rules when describing policy (these are named for economist John B. Taylor, who proposed a formula for linking the central bank policy rate to measures of growth and inflation). However, because these rules can be sensitive to the assumptions that go into them, they produce a range of estimates for the level and degree of change of the policy rate, making them less useful in forecasting the exact timing and pace of cuts. For example, many may remember then-St. Louis Fed President James Bullard's comments in November 2022 about "generous" and "less generous Taylor-type rules," which implied the Fed was nine months late to hike rates in the 2022 cycle. Similarly, those rules today prescribe a fed funds rate below the current fed funds rate range, suggesting the Fed is also late in easing policy.
To augment Taylor rule descriptions of monetary policy, and understand the economic conditions and milestones that may warrant rate cuts, we mined historical monetary cycles for insights. An analysis of 140 central bank rate-cutting cycles across 14 developed markets from the 1960s to today renders several important takeaways.
Returning to today, a range of indicators suggest the U.S. economy is not currently in recession (unlike in Europe and the U.K., where economic indicators are consistent with mild recessions). However, similar to previous non-recessionary rate-cutting cycles, we have seen supply-side improvement that has more than offset still robust demand. As a result, inflation peaked in 2022, and leading indicators suggest it will fall further in the months ahead. Finally, U.S. labor markets have also eased and the unemployment rate has risen 0.3 ppts from its low, approaching the 0.3 to 0.5 ppt zone that historically has been when central banks have begun cutting rates. Unemployment rates in other developed markets have increased more.
Implications for today
Central banks historically have tended to lag in their policy response to economic weakness. Nevertheless, today, with inflation having peaked and the unemployment rate moving up, we are entering the zone in which historically central banks have cut. Furthermore, when central banks do start cutting, those cuts historically have tended to be more aggressive than those implied in the Fed's most recent projections. Even in non-recessionary cutting cycles, central banks cut 200 bps on average in the year after the first cut – about twice the pace currently implied by the SEP.
The dramatic moves in rates markets, which (as of this writing) imply a roughly 70% chance the Fed will be cutting in March and make 160 bps of cuts over the next year, are now pretty close to fully pricing the historical average central bank behavior in a non-recessionary cutting cycle. December's more dovish Fed messages helped prompt these market moves following the hawkish hints back in September.
What does all of this mean? At this point, a soft landing for the U.S. economy appears to be largely embedded in market pricing. For rates markets to deviate from the forward pricing, it would likely be due to evidence of either a deteriorating real economy, which would lead to a recessionary cutting cycle being priced in, or a reacceleration of inflation, which would result in expectations for fewer or slower cuts. In other words, from a near-term trading perspective, we believe the balance of risks in rates markets now looks more symmetrical. This contrasts with riskier assets, however, where both scenarios could negatively affect prices.
This report, like future reports, summarizes the vast array of data analysis that we do at PIMCO. Please don't hesitate to ask us about the underlying data and analysis. If you would like to reach out, please email [email protected].
For regular insights on U.S. policy via email, please write to [email protected] and ask to receive the Washington Watch.
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