Economic Monitor – Weekly Commentary
by Eugenio Alemán

When would it be ok to start cutting rates, and by how much?

December 1, 2023

Our forecast for the federal funds rate has the Federal Reserve (Fed) starting to cut rates in July 2024, with a second rate cut before the end of 2024. Markets seem to believe that the Fed is going to start cutting rates earlier than that and expect more cuts than what we currently expect. Whether we are correct, or markets are, will continue to depend on what happens with inflation and how fast it continues to disinflate. If the disinflationary process continues to accelerate, as we have seen lately, markets may have an edge on the future path of interest rates. However, our belief is that the Fed is more concerned about a potential re-acceleration of inflation, especially if the U.S. economy is able to avoid a recession, and it will be very careful in moving rates lower. The Fed’s thought could be the following: If the economy can handle a 5.5% federal funds rate and still grow unabated, why should it ease? But even if the economy goes into a mild recession, as we are still expecting, the Fed is going to be reluctant to move interest rates much lower fearing that lower interest rates could push inflation higher again.

That is, if the Fed starts lowering interest rates, the credit cycle is going to start again with an increase in lending, and then potentially generate higher economic growth on top of an economy that is already growing above potential. If we, on top of this, add continued geopolitical uncertainty or a successful effort by the OPEC+ cartel to push oil prices much higher, then it is very difficult to see Fed officials accepting stronger economic growth with the potential for a re-acceleration of inflation, especially considering that home prices are on the rise again and the inflationary effects of today’s increase in home prices are going to start making their rounds next year.

This means that the Fed is going to be in a bind again, trying to contain markets’ impulses to move ahead and start pricing in even lower rates earlier. On the flip side, if the economy continues to defy current interest rates, then the Fed will have plenty of arguments to keep interest rates high for longer, which is the opposite of what markets are implying today.

The road ahead will remain as uncertain as it has been, and Fed officials will not want to provide more clarity to the markets. Normally, the Fed doesn’t like to go against markets’ bets on what they expect the Fed to do. This means that, if markets assume the Fed has ended this tightening cycle while the Fed wants to keep interest rate high for longer, it needs to convince markets that it is still serious about its commitment and that is not going to be an easy task.

Consumer spending is slowing down but not collapsing

The data on income and spending for October showed a consumer who is slowing purchases but continues to remain engaged in the economy, with no signs that there may be a hard stop any time soon. Furthermore, real disposable personal income is still growing ahead of real personal consumption expenditures, at 3.9% on a year-over- year basis versus a rate of 2.2%, respectively.

This is, perhaps, the fundamental reason why the economy has continued to remain in expansion, as employment and income have continued to support a healthy growth in income. However, the most notable slowdown in October occurred in the month-over-month rate of growth in wages and salaries, printing a rate of only 0.1% during the month after two consecutive prints of 0.5%. And here is where the slowdown in inflation continues to benefit income earners and consumers. That is, the progress in the disinflationary process, while not acknowledged by consumers, is pulling its punches, as real incomes are still moving higher.

Thus, next Friday’s nonfarm employment report will shed some more light on employment growth as it continues to represent the most important line of defense for Americans as well as for the U.S. economy.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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