Fed to cut in Q3

ANZ Research expects conditions conducive to lower interest rates will emerge in the United States in the middle of calendar 2024, and in response a patient Federal Reserve will move to cut rates in the third quarter.

This is likely to kick off a cycle of cutting ANZ Research expects to reduce rates in the US by 200 basis points from peak to trough, with a terminal range of between 3.25 per cent and 3.50 per cent - implying positive real rates through the cycle.

The drivers are clear. US inflation is subsiding while price moderation is broadening across different categories of consumer inflation, pipeline price measures and wages.

ANZ Research expects US economic growth will weaken in 2024, as the lagged effects of Fed tightening, rising real interest rates, diminished excess savings, weak capital expenditure and slower hiring all weigh on prices.

Restriction

Measured by ANZ Research’s forecast inflation path, the real fed funds rate (FFR) will rise in coming months, increasing the degree of policy restriction in the economy.

Policy settings are already tight and effectively achieving their objectives. The Federal Reserve Bank of Philadelphia’s one- and three-month diffusion indices of coincident state gross domestic product point to a broadening economic deceleration.

In October, the three-month diffusion index showed 16 states experienced economic contraction compared to 10 in September and none at the start of the year. The slowdown can widen further as the lagged effects of earlier monetary tightening and rising real policy rates weigh. ANZ Research does not rule out a brief period of shallow contraction in 2024.

These developments contribute to an expectation of ongoing moderation in both sequential monthly and annual rates of inflation. The need for the Fed to oversee persistently higher real interest rates will subside if the nominal and real economic landscape unfolds as expected.

In response to Fed tightening, normalised supply-chains and a gradual improvement in labour force participation, core US inflation has been slowing sustainably, from an average of 0.4 per cent month on month in the first quarter to 0.21 per cent over the past three months.

The trend improvement is clear, and while there will be bumps along the road, analysis from ANZ Research indicates inflation pressures will continue to gradually moderate. It’s expected core inflation will trend lower as the economy weakens, higher real policy rates squeeze activity and pricing power and the lagged effects of monetary tightening bite, along with reduced excess savings and slower hiring.

Besides an anticipated reduction in annual core PCE (personal consumption expenditure), ANZ Research also expects wage growth will continue to moderate with average earnings growth settling into a non-accelerating inflation rate of pay.

There are encouraging developments across the inflation buckets of goods, shelter, and services ex-shelter. The normalisation in supply chains and re-orientation of spending to services is contributing to aggregate goods-price deflation. Shelter-cost inflation (the largest component of core CPI) has eased, and if recent data is extrapolated, the annual pace of shelter inflation will fall to 4.5 per cent, year on year by the middle of 2024.

There is also evidence emerging services inflation ex-shelter is also moderating. However, that improvement is lagging other key inflation buckets and can be volatile on a month-on-month basis. Nevertheless, the annual trend is down.

CPI services inflation ex-shelter fell to 3.8 per cent, year on year, in October from a high at 6.5 per cent in September 2022. ANZ Research expects the Fed will be patient towards cutting rates until it gets evidence monthly increases in this bucket are sustainably nearing 0.2 per cent. Gauges of inflation, like median and trimmed-mean measures, indicate this should unfold over time.

Meanwhile, the Atlanta Fed’s measure of core sticky goods and services prices excluding shelter fell to 3.0 per cent in October, down from a high at 6.1 per cent in September last year.

Wages are a significant share of the total cost of providing services ex-shelter and, over time, wages and services-ex-shelter inflation move closely together. Wages growth has been moderating in recent times.

ANZ Research expects the moderation in wage growth to continue as the labour market becomes less tight. Indeed, the quits rate, a closely watched measure of labour-market slack, has been easing and is likely to continue to do so as restrictive monetary policy cools labour demand.

Moderate

A 200-basis-point cutting cycle would be a modest one by historical comparison. Since the mid-1980s, the average peak-to-trough decline in interest rates has been 500 points.

The reasons ANZ Research thinks the cycle will be modest are varied. Firstly, the economy requires positive real interest rates to maintain balance given fiscal policy is expansionary and public investment is rising. That is in stark contrast to the post-crisis age of austerity.

Secondly, the US labour market is structurally tight despite an improvement in the participation rate. ANZ Research expects strong demand for skilled workers can support real wage growth with nominal wages running at 3 per cent to 4 per cent, year on year.

Finally, short-run productivity growth may have risen owing to supply-side improvements.

ANZ Research’s profile for rate cuts begins in the third quarter of calendar 2024. The Fed is expected to cut rates gradually as it will want to ensure the broad-based progress on inflation is sustained over the business cycle. ANZ Research expects the federal funds target range will be cut by 50 basis points per quarter until it reaches 3.25 per cent to 3.50 per cent in the second quarter of calendar 2025.

Brian Martin is Head of G3 Economics and Tom Kenny is Senior International Economist at ANZ

This is an edited version of the ANZ Research report ‘FOMC to cut in 2024, with an easing cycle of 200bp’, published November 30, 2023