Australia Exchange Today's News, CICC: When will the Federal Reserve cut interest rates?

CICC released a research report saying that the Federal Reserve's interest rate hike is coming to an end, but officials have hinted that interest rates may be higher and longer (high for longer). So, how long is longer? When will the Federal Reserve turn to interest rate cuts? The bank believes that in the benchmark scenario of the US economy's resilience and slowing inflation, the Federal Reserve's first interest rate cut may occur in September 2024, and the cumulative interest rate cut next year may be around 50 bp. If there are major financial risks before then, the probability of early interest rate cuts will increase; but if inflation stickiness persists, the Federal Reserve may not cut interest rates.

The main points of CICC are as follows:

Looking back at history, there are generally two scenarios for the Federal Reserve to cut interest rates:

One is "data-based" rate cuts, which typically occur when recession, unemployment, and deflation risks have risen significantly, such as in 1984, 1989, 1995, and 2019. The other is "risk management", in which the Fed cuts rates to stabilize financial marekts in the event of sudden financial risk events, such as in 1987, 1998, 2001, and 2007. The US economy has been more resilient than expected this year, the labor market has remained healthy, and the Silicon Valley banking incident has been well handled, allowing the Fed to focus on raising interest rates to fight inflation. Looking back, the market expected the Fed to cut interest rates this year to be too optimistic, and was not prepared for interest rates to stay high for longer.

Will the Federal Reserve cut interest rates in 2024?

The bank can look at both economic data and risk management. In terms of economic data, supported by factors such as a strong labor market, the blessing of the Biden administration's industrial policy, and the stabilization of the real estate market, the real GDP growth rate of the United States in 2023 is expected to reach 2.2%. Entering 2024, the increase in real interest rates may bring about a slowdown in aggregate demand, but the balance sheet of the household sector is healthy, the inventory cycle of enterprises is expected to start, and the economic slowdown may be limited. Under the benchmark scenario, the bank expects that the real GDP growth rate in 2024 can still reach about 1.5%.

In terms of inflation, under the continued tightening of the Federal Reserve, the overall price increase has been basically controlled, but the recent high oil prices, strikes and wage increases have caused supply disruptions, which may make overall inflation "tail up" in the fourth quarter of this year. To be on the safe side, the Federal Reserve may raise interest rates again in the fourth quarter, and the federal funds rate rose to the range of 5.5% to 5.75%. However, core inflation in the United States has not shown signs of rebounding, and the general direction is still trending downward. Looking forward, if oil prices do not rise sharply, consumer inflation expectations remain stable, and the balance between supply and demand in the labor market and the real estate market improves, US inflation may further slow down. The bank's preliminary judgment is that the Fed's most concerned core PCE growth rate range may slowly decline from 3.5% to 4% at the end of this year to 2.5% to 3%.

If the above scenario materializes, then the US economy may achieve a "soft landing", and if core inflation can be reduced to around 3% sometime next year and maintained for a period of time, it will be a success for the Federal Reserve. In fact, the Fed does not necessarily have to reduce inflation to 2%, and appropriately raising the inflation target is also an option. If core inflation can be reduced to around 3% in the first half of 2024, the Fed's main goal may shift from anti-inflation to stable employment, and the room for interest rate cuts may be opened. In addition, the US presidential election will be held in November 2024. On the premise that inflation is under control, pressure from the government may also prompt the Federal Reserve to fine-tune monetary policy.

From a risk management perspective, if a major financial shock occurs, the probability of interest rate cuts will increase.

For example, bank failures, commercial real estate storms, bankruptcies of non-bank institutions, and liquidity crises in the securities and mortgage markets not only affect financial stability, but also pose downside risks to aggregate demand in the economy. Under the premise that inflation is under control, the Federal Reserve may cut interest rates to maintain financial stability and prevent a sharp increase in unemployment, and the balance sheet may re-expand, as it did in response to the Silicon Valley banking incident this year. But financial risks are often unpredictable, and the bank tends to view them as tail risks rather than a benchmark scenario.

To sum up, under the benchmark scenario, the bank expects the Federal Reserve to cut interest rates for the first time in September 2024, and the cumulative rate cut next year may be around 50 bp. If the Federal Reserve does not raise interest rates in the fourth quarter of this year, then the first rate cut next year may be later, and the rate cut will also be reduced accordingly. But if there are major financial risks in the first half of next year, the rate cut time may be advanced, and the rate cut will also increase accordingly.

Finally, one needs to consider a scenario in which US inflation remains sticky and the Federal Reserve does not cut interest rates. One possible scenario is that a supply shock causes inflation to face upside risks, such as higher oil prices and continued increases in workers' wages without productivity gains. A supply shock would also depress aggregate demand, leading to "stagflation". At that time, the Fed's concern about secondary inflation may dominate, and officials may give up the idea of cutting interest rates and keep the policy rate unchanged until the inflation risk is completely lifted.