US Federal Reserve still seeking interest rate sweet spot as fall in inflation slows

While it’s not possible to rule out another US rate rise this year, the Fed looks to be entering a holding pattern
A resilient US economy together with the gradual labour market adjustment means inflation is falling slowly, which will keep rates higher for longer

Kerry Craig

Published: 10:30pm, 1 Sep 2023

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Monetary policy is not the most exciting aspect of the economy, but it is a necessary one that garners a great deal of attention. Markets hang on central bankers’ every word and dissect what is – and often is not – said as they try to gauge where interest rates are heading in both the short and long term.

As such, the annual central banker talkfest at Jackson Hole, Wyoming, was shaping up to be an important event for markets. The title of this year’s symposium – “Structural Shifts in the Global Economy” – was alluring, given that it opened the door for the likes of US Federal Reserve chair Jerome Powell and European Central Bank president Christine Lagarde to discuss events over the past few years and their impact on monetary policy.

Somewhat disappointingly, there was little new in the speeches. Powell repeated many of the themes from recent media events, highlighting that inflation was still too high and a period of subpar economic growth would be needed to get it back to the Fed’s target rate. Further rate increases should not be ruled out if the economy is too strong, he said, or the softening in the labour market doesn’t continue as expected.

All this is to say that the Fed remains data dependent, but aren’t we all? Based on the softer economic data since the Fed last met and the continued bias among several Fed members to raise rates, the September meeting is likely to result in a “hawkish skip”.

This seems to be the view of many, with the market pricing in a high chance that the rate will remain unchanged. However, heading into the November and December meetings, things are more evenly priced between a Fed hold and another rise of 25 basis points.

The US Federal Reserve building in Washington, on August 29, 2023. Market watchers are pricing in expectations that the US central bank will keep interest rates unchanged at its next meeting. Photo: Reuters

While it’s not possible to rule out another rate increase this year, the Fed seems to be entering a holding pattern as the resilient US economy and gradual adjustment in the labour market lead to a slow decline in inflation that will keep rates higher for longer.

This higher-for-longer narrative has pushed yields on US Treasuries higher, adding to speculation about whether the neutral interest rate for the US economy has risen. The neutral level is when rates have neither a stimulating nor restricting effect on economic growth. Like a car idling in neutral, it’s going neither forwards nor backwards.

This long-term neutral interest rate is not something central bankers or markets can observe in real time and is, at best, a guess. As a guide to where the Fed might see this level, we can look at the long-term view of interest rates published each quarter in the Summary of Economic Projections.

Since 2018, the Fed has held the view that the long-term level of rates for the US economy is about 2.5 per cent. The neutral level was higher before this but has declined for a variety of reasons, such as lower growth expectations driven by a worsening demographic profile or lower levels of productivity.

How the US can manage inflation – and stem the obliteration of the middle class

A decline in the neutral interest rate can explain why inflation was hard to generate in the years following the global financial crisis. If the neutral rate was falling, then the Fed had to cut rates even more to achieve a cash rate that would stimulate the economy. When rates got to zero, they needed to do something else; in this case, quantitative easing.

The opposite might be true now. If the neutral rate is rising, the Fed may have to lift rates higher to achieve a level that restricts the economy enough to bring inflation back to the 2 per cent target.

Alternatively, it could also mean that when the Fed does start to cut rates, they will not decrease that much, as the economy could find itself idling comfortably with a higher cash rate. That is, the rate has to be higher just for the economy to be standing still.

Traders work on the floor of the New York Stock Exchange during morning trading on August 31. Stocks on the major indexes opened higher amid the release of inflation data and the Department of Labor’s jobs report. Photo: Getty Images/AFP

Overall, the neutral level of interest rates is a structural variable for an economy, not a cyclical one. In the short term, bond markets and the direction of bond yields are more likely to be concerned with getting a clear signal that the current rate increase cycle has ended, and when rates will start to be cut.

It is likely that 2024 will be a year of rate cuts and falling bond yields which, from today’s level, make the bond market attractive.

Kerry Craig is a global market strategist at JP Morgan Asset Management

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