Not So Fast
The Federal Reserve held its two-day Federal Open Market Committee meeting on September 17th and 18th. Financial markets expected a cut to the Fed Funds interest rate but were fickle about the size. In the week prior to the meeting, markets most strongly favored a 0.25% cut, but by morning of the announcement, it seemed 0.50% was the more expected outcome.1 The Fed delivered the 0.50% cut and thus begins the interest rate cutting phase of this cycle.
The 0.50% interest rate reduction came after Fed officials recalled the importance of its Dual Mandate of both price stability (low inflation) and maximum employment. To quote Chairman Powell at the Jackson Hole Economic Symposium on August 23, 2024, “Overall, the economy continues to grow at a solid pace. But the inflation and labor market data show an evolving situation. The upside risks to inflation have diminished. And the downside risks to employment have increased.”2
Chairman Powell continued, “It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions.”2
That was remarkably clear language from the Fed Chairman. With price growth slowing (inflation) and a badly overheated labor market cooling, the Fed is now just as concerned with jobs as it is prices. Inflation as measured by the Consumer Price Index is accelerating at a pace of 2.41% compared to a year ago rather than an 8.99% yearly pace at its peak growth in June of 2022.3 This still doesn’t hit the Fed’s 2% target, but the significant slowing of growth has given the Fed confidence that 2% is in sight. Meanwhile, a 4.1% unemployment rate is still very good by any historical measure, but higher than the 3.4% unemployment rate in April 2023.4 More insight into the job market’s condition can be gathered by observing the number of job openings versus the number of job seekers. In March of 2022, there were two job openings for each job seeker.5 Today, that number is down to 1.1 job openings per job seeker.5 When the labor market is this balanced, economists expect wages should grow at a pace that won’t exacerbate inflation. This describes the storied Goldilocks soft-landing situation where inflation slows, the economy does not fall into a recession, and employment remains in balance. So far, so good.
With inflation trending towards target and the labor market in better balance, the markets have revived talk of the natural or neutral Fed Funds interest rate and how fast the Fed will get there. The neutral rate is the one that prevails when the economy is operating at its fully sustainable level with little excess pressure on prices or jobs. This is how the Fed knows if its current interest rate policy is too restrictive or too permissive. This neutral rate idea is studied by economists who try to estimate it as closely as possible. However, like most things in economics, the answer is “it depends” and the neutral rate moves around as changes occur in the economy. Using the Fed’s most recent neutral rate model estimation, the neutral real rate is thought to be 0.74%.6 Add the inflation target of 2% and you get a nominal neutral interest rate of 2.74%. We can compare this to the Fed’s Summary of Economic Projection (SEP). The SEP places the long-run Fed Funds interest rate in a range of 2.5%-3.5%.8 That is consistent and recognizes that neutral is a moving target.
How fast might the Fed reach the neutral interest rate range? Today’s Fed Funds target range of 4.75%-5.50% is 2% higher than the Fed’s estimation of long-run neutral from its SEP.7 One way to gauge this is to watch when the futures markets for interest rates adjust their expectations for reaching a 3.50% Fed Funds rate. Shortly after the September Fed meeting, the highest odds of reaching 3.50% fell into the month of May 2025.1 Since then, economic data has been better than expected on Gross Domestic Income8, Payrolls9, and Job Openings10 suggesting that economic growth and jobs may be a little stronger. Then on October 10th, the Consumer Price Index measure of inflation was a little higher than expected.11
Stronger growth and stronger inflation is a recipe for a slower approach to interest rate cuts. These developments have now pushed the highest odds of reaching 3.50% on the Fed Funds interest rate to September 2025.1
The stock market as measured by the S&P 500 Index seems mostly unbothered by the monthly march of stronger versus weaker economic data. It has experienced a few pullbacks over the past year but continues to post new highs. For stocks, it's less about the timing of reaching the neutral rate and more about the direction of travel. Slowing inflation, a more accommodative Fed, a balanced labor market and moderate GDP growth is a great mix for both corporate earnings and stock valuations.
The story is somewhat different for the bond market. Yields on shorter maturity two-year U.S. Treasury bonds and longer maturity ten-year U.S. Treasury bonds are both lower than a year ago. This reflects an expectation for slower inflation, slower economic growth, and lower interest rates from the Fed. But the path lower has been a roller coaster. Going from around 5% yields down to around 3.5% and then recently a sharp move higher to around 4% again is more volatility than bond market investors have experienced in a long time. Like stocks, bonds do care about the direction of interest rates. But because bonds have a maturity date, they care much more than stocks about the timing.
There are two more Federal Reserve meetings in 2024. One is November 6-7 and the last is December 17-18. Chairman Powell has been clear about the Fed’s belief in a lower interest rate path but continues to point the market towards the evolving data to gauge timing. Slower inflation and a more balanced job market versus a year ago lets us retire the phrase “Higher for Longer” when it comes to interest rate expectations. But recent data providing evidence of healthy growth and continued sticky if lower inflation may coin the new phrase “Not So Fast” when thinking about the Fed’s path to neutral.
Tracy Bell, CFA®
Chief Investment Officer
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1 CME FedWatch Tool at https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
2 Federal Reserve Board at https://www.federalreserve.gov/newsevents/speech/powell20240823a.htm
3 Bureau of Labor Statistics at https://www.bls.gov/web/cpi.supp.toc.htm
4 Bureau of Labor Statistics at https://www.bls.gov/cps/cpsatabs.htm
5 Bureau of Labor Statistics data computed by dividing the number of job openings in the Job Openings and Labor Force Turnover Survey by the number of unemployed in the Employment Situation Report
6 Federal Reserve Bank of New York at https://www.newyorkfed.org/research/policy/rstar
7 Federal Reserve at https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20240918.pdf
8 Bureau of Economic Analysis at https://www.bea.gov/data/income-saving/gross-domestic-income#:~:text=Real%20gross%20domestic%20income%20(GDI,real%20GDP%20and%20real%20GDI
9 Bureau of Labor Statistics at https://www.bls.gov/news.release/empsit.nr0.htm
10 Bureau of Labor Statistics at https://www.bls.gov/jlt/
11 Bureau of Labor Statistics at https://www.bls.gov/news.release/cpi.nr0.htm
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