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It was quite a turnaround. Late last year, futures markets had forecast six U.S. interest rate cuts in 2024. As stubborn inflation data continued to come in during the first quarter, traders started to slowly align with the US Federal Reserve’s forecasts for just three. But over the past two weeks, those who expected more cuts this year have started to look like stubborn contrarians.
A third, better-than-expected rise in inflation in the US consumer price index in March was the final straw. Traders have reassessed between one and two rate cuts this year – although zero is also an increasingly popular measure. These measures forced Fed Chairman Jay Powell to make an about-face on Tuesday. He admitted rates may need to stay higher to keep inflation in check. A few months earlier, he had been more optimistic by announcing that reductions were looming. What does this change mean for the economy?
Financial markets remain vulnerable to rising futures prices. After betting too optimistically on six-quarter point cuts, investors dove into stocks and other riskier assets. The S&P 500 rose about 15 percent in the four months to April. But stocks began to fall as the new rate release burst traders’ bubbles. It also means that concerns throughout this rate hike cycle – such as unrealized losses on balance sheets, high real estate debt and hidden leverage in private capital markets – have not gone away.
For now, the overall impact on households and businesses may be limited. Both have largely locked in their fixed rates downward, which partly explains the resilience of the US economy. At the end of 2023, about 70 percent of mortgage holders had rates more than 3 percentage points below the market rate. But those taking out new loans and carrying large credit card balances will be strained even more. Unpaid debts are increasing slightly.
The dramatic change in rate expectations also has political implications outside the United States, having led to a rise in the dollar. For the European Central Bank and the Bank of England, which recently indicated that they could cut their key rates before the Fed, the relative decline of the euro and the pound sterling – which adds to inflationary pressures – complicates their considerations . Asian currencies also suffered heavy selling, with the yen falling to its lowest level since 1990. Markets are on alert for possible monetary interventions by authorities in Japan and South Korea.
This leaves Powell in a pickle. Annual core inflation in the United States is virtually the same as in December. Yet it is also not clear that the disinflation process is over. Price pressures today come from a narrower set of products, including housing and insurance. Signs of a slowdown in the labor market point to a slowdown in persistent services inflation. Holding rates on hold for too long could turn cracks in the strong U.S. economy into a chasm.
However, the stories matter as much as the real economics. After insisting that the Fed would be “data dependent,” the bar will be high to convince markets that rate cuts are justified. Powell could clarify what data the Fed is focusing on and lay out his thinking on medium-term trends; with this anchor, markets could start looking at erratic monthly inflation numbers. But if the Fed itself is unclear about which direction to take, more transparency may do more harm than good.
Israel’s retaliatory strikes against Iran overnight underscore the extent to which the economic outlook continues to be clouded by geopolitics. In times of uncertainty, investors are advised to exercise caution. But markets are also looking to the Fed for guidance. Powell has the thankless task of trying to communicate convincingly in a context of uncertainty. His tone, his word choices, and every inflationary subcomponent will be scrutinized until a credible economic story emerges. Volatility is here to stay. The talk about interest rates has changed once; they might change again.