How fast should US Federal Reserve cut interest rates

DOHA: Forecasting policy rates in the US has been a challenge in recent quarters, after the aggressive monetary policy tightening stabilised with rate...

DOHA: Forecasting policy rates in the US has been a challenge in recent quarters, after the aggressive monetary policy tightening stabilised with rates at 5.5%. This was due to significant volatility in both growth and inflation expectations.

In fact, from late 2023 to early 2024, after a sequence of lower-than-expected inflation prints and weaker GDP growth, markets started to weigh an aggressive schedule of rate cuts. At peak “dovish” expectations in January, markets were pricing close to 200 basis points (bps) in policy rate cuts for this year. But conditions changed markedly throughout the year as three consecutive months of high inflation prints fuelled concerns regarding the disinflation path. This, alongside higher growth expectations, led to a significant re-pricing of short-term interest rates, which were then expected to remain “higher for much longer.” Some analysts and investors even considered the possibility of further rate hikes to prevent a sustained re-acceleration of inflation.

After the latest round of “inflation scare,” softer data for growth and inflation in recent weeks are suggesting that the US Federal Reserve (Fed) should start cutting rates sooner rather than later, kick-starting the monetary policy easing cycle. In our view, the Fed will have room to cut rates at a faster pace than markets are currently expecting, particularly next year. Three main factors sustain our outlook.

First, the disinflationary trend in the US is intact and could accelerate further over the coming quarters, reaching the Fed’s 2% target earlier than previously anticipated. The disinflationary trend has been grounded on supply chain normalization, a moderate slowdown in economic activity, and tighter monetary policy. Core Personal Consumption Expenditures (PCE) inflation, which excludes volatile prices such as energy and food, fell to a new low of 2.6% in June, the slowest pace in more than three years. Importantly, shelter inflation, the main component sustaining core inflation, is set to decelerate further in the coming months, as moderating rental prices are gradually incorporated into new contracts. This will help to cover the proverbial “last mile” gap between the running inflation rate and the inflation target, giving the reassurance that the Fed needs to modify its course.

Second, softening labour markets suggest not only a lack of more structural price pressures from wages, but also even a potential sharp deceleration of economic activity.