Fears of a US recession in the near term have faded recently, but rate cuts are still on the agenda. The combination of a robust economy and expectations for monetary easing strike some observers as misguided, but Federal Reserve Governor Christopher Waller on Monday explained that the central bank is still anticipating that more easing is likely.
The concession to the firmer economic data of late: the cuts will be softer, he noted. But if hawks looking for a sign that cuts were off the table, they were disappointed in Waller’s speech at Stanford University yesterday.
“The data is signaling that the economy may not be slowing as much as desired,” he said. “While we do not want to overreact to this data or look through it, I view the totality of the data as saying monetary policy should proceed with more caution on the pace of rate cuts than was needed at the September meeting.”
In sum, “Whatever happens in the near term, my baseline still calls for reducing the policy rate gradually over the next year.”
Markets agree. Fed funds futures this morning are pricing in high odds that the Fed will trim the current 4.75%-to-5.0% target range by 25 basis points at the next FOMC meeting on Nov. 7.
Meanwhile, the policy-sensitive US 2-year Treasury yield continues to trade well below the current Fed funds target range.
As of Oct. 11, there was a yawning gap between the median effective Fed funds rate and the much lower 2-year yield – a strong sign that the market sees a series of rate cuts in the near term.
A multi-factor model I monitor for TMC Research is also reflecting a strong case for more rate hikes (for details on the inputs, see this research note.) The model’s current estimate of the “optimal” Fed funds rate is roughly 3.4% — sharply below the current target rate.
Meanwhile, another model I track (consumer inflation + the unemployment rate) continues to suggest that monetary policy is tight, which implies that more rate hikes are likely if the Fed is intent on normalizing policy in the near term.
Policymakers at the Fed overall seem to be in agreement that lower interest rates are prudent. As Richard Clarida, former vice-chair of the Federal Reserve and global economic adviser at Pimco, writes on Monday:
“The Fed’s dot plot, a visual representation of policymakers’ interest rate projections, suggests a target for the funds rate of about 3% once inflation stabilises at 2% and the labor market is fully employed.”
The Cleveland Fed’s inflation forecasting model suggests the Fed’s 2% target has been achieved, based on the estimate for the upcoming September report on the price index via personal consumption expenditures data. Meanwhile, US unemployment, at 4.1% in September, is close to the lowest level in decades. Using Clarida’s rules as a guide suggests the odds are fairly high that more rate cuts are coming.