The U.S. Federal Reserve began its regularly scheduled Federal Open Market Committee (FOMC) meeting today. The meeting concludes tomorrow, at which point they will announce their decision on interest rates.
The roller coaster of interest rate cut expectations began last December and has continued through to this year. The market was expecting less (3 cuts), then many more (6 cuts), now far less (1 to 2 cuts). Matco’s rate cut expectations, by comparison, have held steadier. Since June 2023, our anticipation was for 3 rate cuts throughout 2024. Although the Federal Reserve pivot in December caused market expectations to drastically change, we held firm until last week. We have updated our forecast to anticipate 2 rate cuts from the Federal Reserve this year.
What to expect tomorrow:
- The Federal Reserve overnight rate to remain unchanged at 5.50%.
- The Federal Reserve to discuss paring back their balance sheet tapering (reduce quantitative tightening) on the margin.
- Jerome Powell to reiterate, boringly, his comments from April 16th on the lack of progress in returning inflation to its 2% target. Something to this effect:
“The recent data have clearly not given us greater confidence and instead indicate that it’s likely to take longer than expected to achieve that confidence…given the strength of the labor market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work and let the data and the evolving outlook guide us.”
Why the Federal Reserve is nervous about prematurely cutting interest rates.
The visual answer: the picture below, the 1970s-80s inflation experience.
The longer version: In the 1970s inflation was on a high-speed train that ran away from the Federal Reserve peaking at 12.3% in December 1974. The Fed increased rates and successfully reduced inflation to 4.9% by December 1976. However, they had been cutting interest rates and the inflation train took off on the tracks again, peaking at 14.3% in March of 1980. Enter Paul Volcker, who as chair of the Fed dramatically increased interest rates to fight inflation and in the process caused a recession. I likely don’t need to remind many of this era.
The Fed’s caution this time around seems to be a result of the trauma related to historical experience. They are terrified to relive the nightmare of 1970s inflation becoming 1980s inflation. Perhaps warranted, as the scenarios do have similarities. However, one difference worth highlighting, although rarely discussed, is that the labor market had significant slack in it throughout the mid-1970s. When inflation troughed to 4.9% in December 1976, the unemployment rate was at 7.8%. From that point until May of 1979 the labor market continued to strengthen with the unemployment rate eventually troughing at 5.6%. By this time, it was too late, inflation had already resumed its runaway speed on the tracks, in part fueled by increased consumer demand while unemployment trended 2.2% lower.
In the current scenario, the U.S. labor market continues to show signs of strength; strong net monthly job growth (non-farm payrolls) and relatively benign weekly layoffs (initial jobless claims). However, with the unemployment rate at 3.8% there remains little slack in the labor market. It seems far less likely that marginal productivity growth can threaten a rapid rise in inflation. In fact, unemployment has risen from 3.4% (December 2022) to 3.8% (current), moving in the opposite direction as it was in the mid-1970s. Similarly, the underemployment rate troughed at 6.5% (December 2022) and has trended to 7.3% (current). The labor market is currently healthy but loosening, not tightening.
The Bottom Line: The winding road to rate cuts will continue, and the market’s expectations will continue to swing. Canada is certainly likely to cut rates this year, while the Federal Reserve patience will be far greater, but cuts are likely to materialize before year end. With Matco’s Fixed Income portfolio yielding greater than 4% and central bank rate cuts on the horizon, fixed income is well positioned to deliver returns, diversification and downside protection over the next 12 months.
