The logic of a Fed policy pause and then rate cuts in 2024

PERSPECTIVE | January 09, 2024

Authored by RSM US LLP

After nearly two years of raising the federal funds rate to restore price stability, the Federal Reserve has all but declared an end to that campaign.

The major takeaway from the central bank’s recent policy meeting is that the Federal Reserve is forecasting a soft landing and full employment and intends to reduce its policy rate by at least 75 basis points in 2024 to support the expanding economy. This outlook aligns with RSM’s forecast of 100 basis points of cuts that we think will begin in June.

In its statement, the Federal Open Market Committee (FOMC) indicated that current conditions support a continued pause in monetary policy adjustments and a target policy rate between 5.25% and 5.50%. We expect this pause to continue into the middle of 2024 as disinflation continues to work its way through the economy.

The Fed’s quarterly release of its Summary of Economic Projections strongly supports the idea that the economy is likely to avoid a recession and that rate cuts are coming in 2024 as inflation recedes toward the Fed’s 2% target.

The central bank is projecting a long-run unemployment rate of 4.1%, which by any metric implies full employment inside the American economy, even as economic activity moves to its level of sustainable growth of 1.8% per year.

From our vantage point, the December announcement was the best holiday gift a central banker can bestow upon the investment community, policymakers and the public.

So why is a pause necessary?

The Fed maintained rates for one critical reason: the uncertainty of inflationary pressures.

Yes, inflation dropped from 9.1% in June 2022 to 3.1% in November 2023 and will soon be within reach of the Fed’s estimate of price stability. But some prices can be stickier than others.

For instance, while new tenant rents as measured by the Cleveland Fed have stabilized and stand at a 2.7% increase on a year-ago basis, the housing market remains white-hot in some areas, as indicated by the owners’ equivalent rent index, which was up by 6.7% through November and directly affects the headline consumer price index.

And although gasoline prices are dropping, ongoing geopolitical uncertainty could destabilize energy and food prices once again.

While rate hikes have reached the endpoint, that does not guarantee an immediate set of rate cuts, and given the fundamentally strong foundation of the economy, inflation could certainly remain above the Fed’s 2% target for some time. 

The conditions for a pause

The Federal Reserve is charged with maintaining price stability, full employment and financial security. Its most recent statement explicitly points to the risks in the economy as reason enough to continue a wait-and-see policy stance.

But just as important in our view, it also lays out the current positive conditions of stability and growth that we think will allow for the eventual easing of short-term interest rates, most likely in the second half of 2024.

These positive conditions (and their level of uncertainty) include:

• Employment growth: Job creation remains strong, with an average increase of 204,000 in total employment over the past three months, but has moderated since earlier in 2023.
• Low unemployment: The unemployment rate, currently at 3.7%, has been below 4% for the past 22 months and remains well below any measure of the natural rate of unemployment. But while the labor force continues to grow in response to higher wages, the lagged impact of tighter financial conditions is also a factor. Those conditions are likely to affect economic activity and hiring in the near future.
• Inflation: The consumer price index has eased over the past year, falling to 3.1% in November, but it remains elevated compared to the Fed’s stated 2% inflation target.
• Financial system: The U.S. banking system is sound and resilient.

In our view, the word “elevated” in the Fed’s assessment of inflation is explicit advice for the financial markets to not get ahead of the Fed’s determination to fully squash inflation.

As of Dec. 15, the forward market continued to price in a rate cut as early as March, followed by rate cuts in six of the following seven FOMC scheduled meetings. We think such an outlook is unrealistic given the underlying strength of the economy.

We expect the pause to last until there are sure signs either that the owners’ equivalent rent series inside the consumer price index is easing faster, or that there is a quicker move toward the Fed’s 2024 year-end target of 2.4% in the core personal consumption expenditures index.

In any case, at some point the Fed will adjust its forward guidance and prepare investors, policymakers and the public for a policy of gradual cuts as it has done in the past business cycles. We expect that to happen no later than the middle of 2024.

The logic of Fed rate cuts

While we think that the market’s estimate of the timing and magnitude of rate cuts appears somewhat premature, the logic of why the Fed will cut rates is increasingly coming into view as inflation eases and policy decisions made before and during the pandemic continue to reverberate.

Much of the euphoria that has influenced pricing across asset markets at the end of 2023 has to do with the idea that the fight against inflation is over and that the Fed is poised to begin cutting rates sooner than expected.

Yet with inflation easing back toward tolerable levels of around 2.5%, there is no reason why the Fed needs to maintain a restrictive policy rate near 5.5%.

Our estimate of the new Fed neutral rate is between 3% and 3.5%. We expect that as the central bank grows more confident in the direction of inflation, it will begin to cut rates, especially after what we think will be lackluster growth in the first half of the year, when we expect growth to be 1.3%.

In addition, the Fed is now pivoting to stabilize real interest rates, which are sitting near 2.5% in contrast with the 0.26% over the past decade. As inflation recedes, real interest rates can still increase as the Fed’s policy rate remains unchanged during the first half of 2024.

We expect the Fed to begin using its power to shape markets through its statements to stabilize and prepare the public for those rate cuts. Short-term interest rates are in restrictive terrain and do not need to remain there as inflation continues to abate.

Risks on the horizon

From our vantage point, the best monetary policy is forward-looking and manages risk. By the second half of 2024, central bankers will be looking to ascertain risks that loom just over the horizon.

Those risks have to do in part with the historically low interest rates put in place in 2020 and in part with the scheduled expiration of the 2017 Tax Cuts and Jobs Act in 2025.

First, corporate debt that was taken on at the historically low interest rates put in place in response to the pandemic in 2020 will need to be rolled over starting in 2025 at much higher rates. More than $3 trillion in debt needs to be rolled over in the coming years at rates much higher than in 2020, according to the Financial Times.

For example, a 5% rate on $800 million in debt issued in 2020 will simply not be replicated in 2025. The more likely scenario is that bankers will be willing to make similar loans at 8% but at lower levels, near $500 million.

That creates a $300 million gap that needs to be filled—probably by private credit and other shadow-banking actors, if it is filled at all. That gap, in turn, creates risk through the financial channel to the domestic corporate sector.

If the Fed wants to risk higher unemployment and tipping over of the economy, one way to do so is to keep the federal funds rate where it is and let real interest rates rise.

Our policy evaluation is that Fed policymakers will simply not do that.

This maturity wall will play a much larger role in the policy narrative both inside the central bank and in Washington, where the issue is already being discussed ahead of what will be another contentious election year.

The second risk for the central bank is that the expiration at the end of 2025 of the tax cuts enacted in 2017 will create a significant tax cliff for the economy.

Based on our discussions with policymakers inside the nation’s capital, this expiration is already at the top of the policy agenda.

It is clear to both sides that letting the corporate tax rate reset to levels that existed before 2017 is in no one’s best interest given the current higher level of interest rates.

The takeaway

Our evaluation of monetary policy implies that the Federal Reserve will reduce rates to protect the real economy in 2024 as inflation eases. But first it needs to wrap up its current policy path.