Macroscope | Low inflation, interest rate cuts and no recession in 2024? Not so fast

There is reason for optimism after the Federal Reserve’s surprise interest rate decision, but there are also still plenty of reasons for caution

The fact that markets are expecting the smoothest of touchdowns for the US economy next year should be ringing alarm bells

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US Federal Reserve Chairman Jerome Powell speaks at a press conference in Washington on December 13 after the US central bank decided to keep its benchmark interest rate unchanged for the third consecutive time. Photo: Kyodo

Published: 7:30pm, 21 Dec 2023

Christmas came early for financial markets. Last week, the United States Federal Reserve, the world’s most influential central bank, delighted investors when it unexpectedly signalled that its interest rate-raising campaign was over and that it anticipated that borrowing costs would fall by three-quarters of a percentage point next year.

While a reduction in US interest rates had been priced in, the Fed “out-doved” the markets by sounding even more dovish than traders expected. In the space of a fortnight, Fed chairman Jerome Powell changed the narrative around monetary policy dramatically. Having earlier insisted that it was premature to speculate on the timing of rate cuts, he sang a different tune on December 13 when he revealed that the Fed had discussed when they should begin easing policy.

For markets, the policy shift was hugely consequential. In addition to predicting a further drop in inflation next year, Powell also sounded more confident that a recession could be averted, reinforcing the perception that the US economy is headed for a “soft landing”. According to Bloomberg data, markets had their best “Fed day” since 2009, with all major asset classes enjoying gains of at least 1 per cent in response to the Fed’s dovish pivot.

The results of Bank of America’s latest poll of global fund managers, published on Tuesday, showed that sentiment was the most upbeat in almost two years. Two-thirds of respondents expected a soft landing for the global economy, 80 per cent anticipated lower inflation, while a record percentage believed government bond yields would be lower a year from now.

There is undeniably much to be pleased about, especially in the US. Headline inflation in the euro zone has fallen to just 2.4 per cent, only slightly above the European Central Bank’s target and down from more than 10 per cent a year ago. In the United States, inflation stands at 3.1 per cent, compared with 3.9 per cent in Britain. More surprisingly, the much-anticipated recession in America never materialised. The US consumer has proved remarkably resilient, supported by a strong labour market.

Yet, there are also plenty of reasons for caution. Investors have a selective hearing problem: they are overreacting to positive signals while downplaying or ignoring negative ones. There are three reasons the “Goldilocks scenario” that many fund managers are betting on – lower inflation, aggressive rate cuts and decent growth – looks far-fetched.

.css-1m2rp1p{color:#34b8b5;}Macroscope | Low inflation, interest rate cuts and no recession in 2024? Not so fast

Macroscope | Low inflation, interest rate cuts and no recession in 2024? Not so fast