Infocus - Turning points and Fed policy

The level of the Fed funds rate is one of the most important parameters for financial markets because so much else is priced off it. With the approaching 18 September meeting of the Federal Open Market Committee (FOMC), Daniel Murray discusses the relationship between markets and the Fed funds rate.

When the Fed funds rate moves, that has broad and important consequences for financial markets internationally. It is therefore important for market participants to form a view regarding where they think the Fed funds rate will be at future points in time. Whilst it may be desirable from a stability perspective for those views to change only slowly, it is also appropriate and inevitable that occasionally there will be large surprise moves in response to incoming data.

Changing expectations

At the beginning of the year, futures markets were pricing in nearly seven rate cuts (of 0.25% each) from the Federal Reserve in 2024. By the end of April that had fallen to only one Fed rate cut this year, before spiking to five during the market volatility that transpired in early August. Currently, the market expects between three and four rate cuts to the end of December, spread over meetings on 18 September, 7 November and 18 December.

The focus now is on the September meeting, for which expectations have been similarly changeable. At the peak of recent market nervousness, futures were pricing in with 100% certainty a rate cut of 0.50% at the September FOMC meeting. As at the time of writing, the probability of a 0.50% cut at that meeting has declined to only 35%.

In practice there is a wide range of views regarding the September FOMC meeting, from those who expect the Fed to remain on hold to those who expect a cut of 0.50% or more. Similarly, there are some people who believe the Fed will be on hold into year end and others who think the Fed funds rate will end the year a full 1.00% or more lower than where it is today.

Whoever is able to anticipate correctly the path of the Fed funds rate will no doubt attract much kudos and bragging rights. However, in practice there is so much data between now and the September meeting - let alone to end December - that it is difficult to predict what the Fed will do.

Fed’s reaction function

What we can do is anticipate the Fed’s actions contingent on the incoming data. In a report earlier this year, a table was presented that simplifies the Fed’s reaction function to the incoming data under different scenarios. That table is repeated in Figure 1 for reference.¹

Currently the labour market is tight although it has weakened in recent months at a gentle pace. At the same time, inflation is above target but declining. According to the table, this suggests that the Fed’s decision is currently finely balanced. Indeed, it is notable that some Fed officials recently indicated that they are not yet ready to support a rate cut.² It may be appropriate for the Fed to cut in September by 0.25%, 0.50% or perhaps not to cut at all. It will depend on what the data points to regarding the state of the economy at the time of the next FOMC meeting.

None of us can predict with certainty what the data will be so none of us can be sure how the Fed will react. Nevertheless, it is incumbent on investors to take a view as to the likelihood of different outcomes. It is therefore instructive to perform a scenario analysis, shown in Figure 2 (on Page 2).

Figure 3 illustrates the different scenarios graphically. Starting from core personal consumption expenditures (PCE) inflation of 2.6% and an unemployment rate of 4.3% in the centre of the chart, the further we move to the upper left, the more dovish is the Fed likely to be. Similarly, the further we move to the bottom right the more hawkish the Fed is likely to be. If inflation declines at the same time as the labour market tightens, it is not clear how the Fed would react; it would depend on a broader view of the economy and how the Fed believes it will evolve. The Fed’s reaction if inflation increases as labour markets weaken is also uncertain; the Fed would not want to compromise its inflation fighting credentials but at the same time would not want to contribute unnecessarily to economic hardship. Again, it would depend on a broad range of factors.

In this context, the most important data points to monitor over the next few weeks are shown in Figure 4.

In addition, the Jackson Hole Economic Symposium - taking place this year from 22 to 24 August - has in the past often been used by the Fed and other central banks to communicate with the market.

Supplementing the data in this table with information gleaned from other sources such as company releases will provide an additional important source of intelligence.

Conclusion

In conclusion, market expectations are fickle. They change quickly from one day to the next dependent on the incoming data and its interpretation. That uncertainty becomes more elevated at potential turning points in the policy cycle, such as we are experiencing today. It is therefore helpful to think about the range of outcomes in terms of their probabilities, as illustrated in Figure 2.

Our core view remains that the Fed will cut by 0.25% in September and by three times this year. This is slightly less dovish than current market expectations. If the incoming data confirms an upward left move in Figure 3, this will increase the likelihood that the Fed is more dovish. If the incoming data is consistent with ongoing tight labour markets and stubborn inflation that will encourage the Fed to do less. At the same time, the yield curve is expected to steepen more from the short end as and when the Fed becomes more dovish.

¹ See ‘Deciphering the Fed’, EFG Macro Flash Note, 21 March 2024. https://www.efginternational.com/uk/insights/2024/deciphering_the_fed.htm

² “Barkin says Fed has ‘Time’ to assess economy, determine response” Bloomberg, 8 August, 2024.
“Fed’s Schmid says ‘We are not quite there’ in cooling inflation” Bloomberg, 9 August, 2024.
“Fed’s Bowman signals caution on rate cuts” The Economic Times of India, 12 August, 2024.
“Fed’s Bostic says more data needed, rate cut likely by year-end” Bloomberg, 13 August, 2024. It is also true that two days after Bostic made this statement he said that he is “open” to a September rate cut.

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