Rate cuts and a soft landing: This will be a critical year for the Fed

Washington, DC (CNN) — The stakes could not be higher for the Federal Reserve this year.

America’s central bank is on the verge of defeating inflation without causing a sharp rise in unemployment, an extremely rare feat known as a “soft landing.” Last year, as inflation drifted to its slowest annual pace in two years, unemployment remained low and Americans continued to spend, despite the highest interest rates in 22 years.

Not only has that raised hopes of a soft landing, but it has also sparked discussions over the next crucial phase of the Fed’s historic inflation fight: Cutting interest rates.

The Fed clearly signaled it intends to begin to cut rates this year, giving Americans some much-needed respite from the tough borrowing costs buffeting the housing market and looming over companies set to refinance corporate loans soon.

Fed Chair Jerome Powell said last month that “you want to be reducing restriction on the economy well before 2%,” and that waiting to cut rates until inflation reaches 2% would “be too late.” Inflation is currently running below 3%, according to the PCE, and central bank officials have signaled that rates are well into “restrictive” territory.

The timing of that first rate cut, however, and how many there will ultimately be this year, is where things become muddled. Officials penciled in three rate cuts for 2024, according to their latest economic projections released in December, but markets are pricing in double that amount, beginning as soon as March.

“It’ll be somewhere in between,” Maxime Darmet, a senior economist at Allianz Trade, told CNN. “But I do think the market is getting ahead of itself.”

Whatever turn the economy takes in 2024, this will be a critical year for the world’s most powerful central bank.

Here’s how rate cuts will be decided

Investors and the Fed both agree that rates will need to come down in 2024, based on the US economy’s direction. Hiring, growth, and inflation all slowed gradually last year, and that steady slowdown is expected to persist.

“Typically, a weakening labor market, below-trend economic growth, and on-target inflation have served as prerequisites for a rate cut,” Seema Shah, chief global strategist at Principal Asset Management, wrote in a recent note. “It is more likely that clear evidence of an economic slowdown will take longer to emerge, possibly around mid-year.”

As long as the Fed’s key rate is left unchanged, inflation-adjusted interest rates (the so-called real interest rate) may rise, as price hikes continue to ease. Powell said last month that this would be yet another variable officials consider when deliberating rate cuts. Rising real interest rates unnecessarily constrain economic activity.

The Fed has been carefully balancing the risk of inflation stalling or reigniting with the risk of the central bank’s actions inadvertently causing undue economic damage. As 2024 progresses, the upside risks to inflation could diminish, allowing the Fed to just focus on leaving the economy intact if inflation is on a certain path to 2%, according to economists.

As Powell has said, the Fed considers “the totality of the incoming data, the evolving outlook, and the balance of risks” when deliberating the timing and pace of rate cuts. But that timing is precisely where the Fed and Wall Street seem to diverge.

Goldman Sachs economists expect rate cuts to begin in March, followed by two others later in the year. Bank of America also sees rate cuts beginning in March. JPMorgan’s chief US economist, Michael Feroli, sees five quarter-point rate cuts this year, beginning in June.

After deciding to hold rates steady for the third consecutive meeting last month, Fed officials have tried to calm seemingly overeager investors.

“We aren’t really talking about rate cuts,” New York Fed President John Williams told CNBC last month. Chicago Fed President Austan Goolsbee told CBS recently that inflation remains above target and that “it’s an overstatement to be counting the chickens.”

But, despite such comments, the odds of a March rate cut have improved in recent weeks, according to futures.

Another important development for the rate-cuts discussion is how sharply bond yields have fallen in recent weeks. When yields briefly crossed 5% in November, Powell and other officials said that was helping do the Fed’s inflation-easing work for it. The 10-year US Treasury note is the benchmark for interest rates on various lending products, from car loans to mortgages.

Since then, the 10-year yield has dipped below 4%. If yields slide further, that could mean fewer rate cuts or a first cut coming later than expected.

“We are seeing a large easing of financial conditions and that’s not something the Fed is very happy to see,” said Darmet of Allianz Trade. “If financial conditions ease too much, there is a risk that the economy picks back up [in 2024] and if the economy does pick back up, that could reignite inflation.”

Sticking the soft landing?

It’s been nearly two years since the Fed began to lift rates, and the central bank already has plenty to be grateful for. Price increases have retreated from their four-decade high in mid-2022 as the unemployment rate remained under 4% and Americans continued to fuel economic growth with their spending.

The US economy is now running at a softer pace than the gangbusters years of 2021 and 2022, but hiring and spending remain solid.

The question is whether this resilience could persist this year as inflation continues to recede, cementing a soft landing.

Conventional wisdom has it that a soft landing has only occurred once, in the 1990s; but some argue there have actually been a handful. The main aspect of a soft landing is the absence of a recession as inflation inches toward 2%. So far, the US economy seems to be on track.

In November, consumer prices fell on a monthly basis for the first time in more than three years, according to the Personal Consumption Expenditures index, the Fed’s preferred inflation gauge. From a year earlier, prices rose 2.6%, down from October’s 2.9% rise, also marking a major improvement from the 40-year high of 7.1% notched in June 2022.

Fed officials estimated in their December projections that they expect inflation to slow faster in 2024 than previously thought, but that inflation won’t reach 2% until 2026.

They also expect growth to register at a healthy 1.4% annualized rate this year. Most economists have similar growth forecasts for 2024; weaker than 2023, but still decent, slightly above a 1% rate. In a recession, growth contracts.

As Treasury Secretary Janet Yellen said recently, there is always a risk of a recession in any given year, and of course, there will always be bearish pundits declaring imminent doom and gloom. However, after a remarkable 2023, the bulls have built up a case for a soft landing this year.

Some say the Fed may have already pulled off a soft landing.

“We are heading towards that 2% target and the economy is still moving forward, we haven’t seen a recession, so essentially to some extent, you could say that a soft landing has been achieved,” Gregory Daco, chief economist at EY-Parthenon, told CNN.

“The key question now is whether there is a sufficiently long and stable runway through ’24 so that we avoid that long-feared recession,” he said.

Resilience was the economy’s biggest surprise in 2023. Some more of that may be needed for the Fed to ultimately stick a soft landing, but in the end, only time will tell.

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