Wall Street rejects rate cut expectations and sees risk of no action until 2025

If there was any doubt before, Federal Reserve Chairman Jerome Powell has largely cemented the likelihood that interest rate cuts won’t happen any time soon.

Now Wall Street is wondering whether the central bank will cut rates at all this year.

That’s because Powell said Tuesday there is “no further progress” in bringing inflation down to the Fed’s 2% target, meaning it will “likely take longer than expected” to gain enough confidence to begin easing. politicians.

“They have the economy exactly where they want it. Right now they’re just focused on the inflation numbers. The question is, what is the bar here?” said Mark Zandi, chief economist at Moody’s Analytics. “I believe they need two, perhaps three consecutive months of inflation data that is consistent with the 2% target. If that’s the bar, the earliest they can hit it is September. I just don’t see rates coming down before then.”

With most indicators showing inflation to be around 3% and not expected to move much for several months, the Fed finds itself in the final stretch of its goal.

Market prices for rate cuts have been extremely volatile in recent weeks as Wall Street chased the Fed’s volatile rhetoric. As of Wednesday afternoon, traders put the likelihood of the central bank actually waiting until September at about 71%, with an implied chance of a rate cut in July at 44%, according to CME Group FedWatch to measure.

As for the second rate cut, there was a bias towards it in December, but this remains an open question.

“Right now I have two base case scenarios — one in September and one in December, but I can easily foresee one rate cut, in November,” said Zandi, who believes the presidential election could change the equation for Fed officials who insist that they are not influenced by politics.

Uncertainty spread across the Street. The market’s implied odds of no cuts this year stood at around 11% on Wednesday, but the possibility cannot be ignored for now.

For example, Bank of America economists said there is a “real risk” that the Fed won’t cut until March 2025 “at the earliest,” although for now they’re still sticking with their December forecast for a single cut. year. At the start of 2024, markets were forecasting a decline of at least six-quarter percentage points.

“We think policymakers will be uncomfortable starting a tapering cycle in June or even September,” BofA economist Stephen Juneau said in a note to clients. “In short, this is the reality of the data-driven Fed. With inflation data set to beat expectations at the start of the year, it would not be surprising that the Fed would resist any immediate rate cuts, especially given the strong economic activity data. “

Of course, there is still hope that inflation data will decline in the next few months and give the central bank the opportunity to ease the situation.

Citigroup, for example, still expects the Fed to begin easing policy in June or July and cut rates several times this year. Powell and his fellow policymakers “will be pleasantly surprised” by inflation data in the coming months, wrote Citi economist Andrew Hollenhorst, adding that the Fed is “prepared to cut rates either because core inflation slows year-on-year or because of any signs of weakness ” in activity data.”

Elsewhere, Goldman Sachs moved up the month it expects policy easing, but only to July from June, as “the broader deflationary scenario remains unchanged,” wrote Jan Hatzius, the firm’s chief economist.

If true, “the pause on rate cuts will be lifted and the Fed will move forward,” wrote Krishna Guha, head of global policy and central bank strategy at Evercore ISI. But Guha also noted the wide range of policy options Powell opened up in his speech Tuesday.

“We believe this still leaves the Fed uncomfortably at the mercy of the data and very vulnerable to a cut from three to two to one if near-term inflation data doesn’t match up,” he added.

The possibility of Fed stubbornness raises the possibility of a policy mistake. Despite the strength of the economy, higher rates over longer periods could threaten the stability of the labor market, not to mention areas of the financial sector such as regional banks that are exposed to the duration risk associated with fixed income portfolios.

Zandi said the Fed should have already been cutting inflation with inflation already peaking in mid-2022, adding that housing-related factors are essentially the only thing standing between the central bank and its 2% inflation target.

The Fed’s policy mistake “is the most significant risk to the economy right now. They have already achieved their full employment mandate. They have almost met their inflation mandate,” Zandi said.

“Things happen, and I think we need to be humble with the financial system,” he added. “They run the risk of breaking something. And for what purpose? If I were on the committee, I would strongly insist that it’s time for us to go.”