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Investment markets have just got very interesting. Whilst the Bank of England held fast on further rate cuts this week to see how their prior cut was impacting on markets, the US Federal Reserve (Fed) has surprised some parts of the markets by cutting interest rates by 0.5%. This was the first cut by America’s central bank since it lifted rates to tackle inflation, and most importantly the shift marks the formal start of a monetary-easing cycle. It also represents a bet that inflation will soon be yesterday’s problem, and that action is required to support the labour market.
When the Fed raised rates between early 2022 and mid-2023, it telegraphed the size of each rise in advance. This time there was uncertainty about how big the reduction would be. A week earlier, market pricing implied roughly 65% odds that the Fed would cut rates by 0.25%. This had flipped by Tuesday this week, with 65% expecting a 0.5% rate cut. That some investors, albeit a minority, were still positioned for a smaller move helps explain why stocks rallied after the Fed opted for a bigger cut.
The argument for a 0.5% cut rests on several pillars. Crucially, the Fed is confident that it is on track to bring inflation under control. Price rises have slowed to an annual pace of 2.5%, not far from its target of 2%. With oil prices sagging and rents rising more slowly, there is a good chance that inflation will soon ease further. Therefore, the Fed’s worries have shifted to the job market. The unemployment rate of 4.2% is low, but nearly a full percentage point higher than early last year and companies have cut back on their hiring. Jerome Powell, the Fed’s chair, portrayed the rate cut as a recalibration of monetary policy in line with a lessening of inflation risks and an increase in unemployment risks. He is trying to maintain the image that this was their plan all along and they are fully in control. If the markets believe him, this could be a very strong period for equities, especially those left behind by the tech rally of the last 18 months.
Mr Powell’s cut is also a form of insurance. It takes months for rate reductions to filter through the economy. Given this lag and given the expectation that the economy will continue to slow, it makes sense for the Fed to make a bigger move now in order to get ahead of the coming weakness. The central bank was late in raising rates in 2022. This time, it hopes that starting with a bigger cut will steer the economy towards a soft landing, avoiding the recession which many analysts once thought inevitable. “We don’t think we’re behind,” said Mr Powell. “We think this is timely. But I think you can take this as sign of our commitment not to get behind.”
According to projections released on September 18th, the median forecast of Fed officials is that they will reduce rates by another 1.25 to 1.50% by the end of next year. They could easily make fewer cuts if inflation proves to be more stubborn.
This rosy outlook depends on a few roadblocks that need resolving. Geopolitical tensions are rising. Coming just before the presidential election, the big rate cut may attract criticism from Donald Trump, fresh from a further assassination attempt. He could see this as a sign that the Fed, a frequent target of his ire, is trying to help Kamala Harris. Yet a quarter-point cut could just as easily have invited a complaint from Democrats that Mr Powell had been intimidated by Mr Trump. Mr Powell has long said that he tunes out the political noise. Tensions have also further risen globally after the attack on Hezbollah this week that will surely draw a response.
For now, I hope that the prospect of an improved outlook for investment markets puts a spring in your step, a welcome break from the more gloomy recent news in the UK on the forthcoming budget, NHS reforms and the Starmer’s wardrobe. Do have a good weekend.
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