Chief Economist Eugenio J. Alemán discusses current economic conditions.
Our forecast for the federal funds rate has the Federal Reserve (Fed) starting to cut rates in July 2024, with a second rate cut before the end of 2024. Markets seem to believe that the Fed is going to start cutting rates earlier than that and expect more cuts than what we currently expect. Whether we are correct, or markets are, will continue to depend on what happens with inflation and how fast it continues to disinflate. If the disinflationary process continues to accelerate, as we have seen lately, markets may have an edge on the future path of interest rates. However, our belief is that the Fed is more concerned about a potential re-acceleration of inflation, especially if the U.S. economy is able to avoid a recession, and it will be very careful in moving rates lower. The Fed’s thought could be the following: If the economy can handle a 5.5% federal funds rate and still grow unabated, why should it ease? But even if the economy goes into a mild recession, as we are still expecting, the Fed is going to be reluctant to move interest rates much lower fearing that lower interest rates could push inflation higher again.
That is, if the Fed starts lowering interest rates, the credit cycle is going to start again with an increase in lending, and then potentially generate higher economic growth on top of an economy that is already growing above potential. If we, on top of this, add continued geopolitical uncertainty or a successful effort by the OPEC+ cartel to push oil prices much higher, then it is very difficult to see Fed officials accepting stronger economic growth with the potential for a re-acceleration of inflation, especially considering that home prices are on the rise again and the inflationary effects of today’s increase in home prices are going to start making their rounds next year.
This means that the Fed is going to be in a bind again, trying to contain markets’ impulses to move ahead and start pricing in even lower rates earlier. On the flip side, if the economy continues to defy current interest rates, then the Fed will have plenty of arguments to keep interest rates high for longer, which is the opposite of what markets are implying today.
The road ahead will remain as uncertain as it has been, and Fed officials will not want to provide more clarity to the markets. Normally, the Fed doesn’t like to go against markets’ bets on what they expect the Fed to do. This means that, if markets assume the Fed has ended this tightening cycle while the Fed wants to keep interest rate high for longer, it needs to convince markets that it is still serious about its commitment and that is not going to be an easy task.