When Will Interest Rates Fall and by How Much?

UBS analysts think the Fed will need 6 months or so to realize it can ease, gradually slicing the central bank’s benchmark by a modest amount, up to 0.75 points.

Wall Street is convinced the Federal Reserve will cut rates next year, and the only questions are: When will the reductions start, and how deep will they go? Representatives from the Fed, for their part, wave away talk about reversing the tightening campaign, saying it is not clear that rising inflation is vanquished.

Still, investment firms are not convinced today’s rate level will persist, with the UBS view a prime example. The bank’s strategists argued in a note that the Fed will lower rates by next summer as it comes to realize that its benchmark is perhaps one percentage point too high for the economy’s health. By mid-year 2024, the thinking goes, inflation should be down sufficiently to permit a reduction.

The cuts, however, will be, in UBS’s estimation, up to a total of 0.75 points. If so, that would put the rate closer to the long-term average (since World War II) of 4.6%. “Our base case is that the Fed will deliver two to three cuts next year, with the timing data dependent, but most likely starting in July,” the report stated. UBS reasoned that “policymakers will be sufficiently confident by mid-year that inflation is falling sustainably toward target to begin cutting rates.”

UBS and other firms hear Fed Chair Jerome Powell say that the benchmark federal funds rate (now in a band from 5.25% to 5.5%) is “restrictive.” By their reasoning, Powell will not want to keep rates that high for too long, lest economic growth suffer. Already there are indications that the economy may be downshifting, with hiring off from its highs and consumer spending decelerating.

Also helping to fuel expectations of Fed easing is that inflation has indeed cooled, although not yet reaching the level the central bank wants. The Personal Consumption Expenditures Index, the Fed’s preferred inflation gauge, was 3% yearly as of October, its smallest year-over-year gain since March 2021 and down from 3.4% in September. The Fed’s PCE target is 2%.

The betting in the futures market is for five reductions, each by one-quarter of a point, by December 2024, with 60% odds that the first cut comes as early as March. The wagering is almost unanimous that the Fed’s policymakers will do nothing at their meeting on December 12 and 13.

The bond market has begun to reflect the easing expectations: The 10-year Treasury yield has tumbled to 4.4%, as of Friday, from near 5.0% in mid-October. Meanwhile, over the same period, the two-year Treasury has slid to 4.7% from 5.1%.

The UBS note pointed out that statistical progress on inflation and the bond market’s performance, a good gauge for investors’ views on Fed policy, will not move in a straight line in coming months. Exogenous events, such as international tensions, always can crop up to disrupt rosy scenarios.

The memory is strong of 2021, when inflation jumped in the spring and then subsided in the summer, giving the Fed false hope that the surge was, in Powell’s words at the time, “transitory.” Amid supply-chain snafus, prices resumed their ascent in the fall.

The hope—and expectation—is that next year’s story will be different.

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