What will happen if the Federal Reserve doesn’t lower interest rates in 2024? That isn’t an unimaginable scenario anymore, given the economy’s persistent strength and still-elevated inflation.
Nor would it be the end of the world for equity investors.
Recent economic data hardly argue for a near-term rate cut, even though the Fed has signaled it is likely to lower rates this year, with markets expecting a cut as soon as June. The labor market has loosened over the past year but remains tight. Job openings exceed available workers, and real wages are rising.
Financial conditions are relatively easy, as measured by a variety of indexes that track asset prices, the availability of credit, and borrowing rates, among other factors. And economic growth expectations for 2024 have increased.
Meanwhile, progress on cooling inflation seems to have stalled. After trending lower for most of 2023, inflation readings for January and February surprised to the upside. The March consumer price index, due to be released on April 10, will be closely watched for confirmation or repudiation of that trend.
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The Fed, which raised interest rates in the past two years to tame economic growth and reduce inflation, has committed to making interest-rate decisions on a meeting-by-meeting basis, based on incoming data about both. Recent readings have surprised to the upside.
Indeed, economists and market strategists have consistently underestimated the strength of the economy over the past year. If March and April data on inflation and economic growth resemble releases for January and February, interest-rate reductions will become increasingly unlikely in 2024.
“It’s certainly possible that the Fed doesn’t cut at all in 2024,” says Seamus Smyth, chief economist at Virtus Investment Partners. “All it takes is the next few inflation prints not cooperating.”
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Smyth puts the odds of a zero-cut 2024 at about 20%. His base case is for three quarter-point reductions this year, beginning in June.
Interest-rate futures markets aren’t on board with the no-cuts scenario, either. Pricing on Wednesday implied a less than 1% likelihood of the federal-funds rate ending 2024 in its current 5.25% to 5.5% target range.
“While nowhere close to a consensus view, the idea of no cuts in [2024] has started to creep ever so slowly into the margin of the possible Fed paths going forward,” wrote Scott Pike, senior portfolio manager at Income Research + Management, after the Fed’s March policy meeting. “For this to occur, we would need to see the confidence that the Fed is seeking in terms of inflation continuing on its path to 2% remaining elusive, given stubbornly high inflation prints.”
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Policymakers around the world are trying to chart a course between cutting rates too soon and risking a reacceleration in inflation that would require even tighter monetary policy in the future, and holding rates high for too long, thus tipping the economy into recession. For now, the Fed is taking a wait-and-see approach.
It is possible that Fed officials won’t gain confidence this year that inflation is trending sustainably toward the central bank’s 2% annual target, in which case they might remain on hold for the rest of the year.
“A data-dependent Fed should consider a different, emerging risk: the risk of no landing, or an economy that threatens to overheat,” Vanguard global chief economist Joe Davis wrote in a recent guest column for Barron’s. He pointed to the late 1960s, when the Fed began cutting interest rates ahead of expected cooling in the economy but was then forced to raise them even higher to rein in resurgent inflation.
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“The parallels between today and 1967 offer the lesson that if a prudent Fed does not want to raise interest rates in 2025, it might choose to forgo rate cuts in 2024,” Davis wrote.
That isn’t all bad news for investors. Stock returns in the period between the Fed’s last rate increase and the first decrease of a cycle have historically been strong, according to Bespoke Investment Group. Sure, some of that may be because investors are expecting cuts. But it is also a positive that the economy doesn’t need rescuing.
Stronger growth means higher earnings from more industries and companies. That’s a recipe for a broadening out of the stock market rally, driven by fundamentals. Bond yields would rise in a zero-cut 2024, but stocks needn’t crash.
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com