Within the past week, both the US Federal Reserve and – more surprisingly – the Bank of England have chosen to leave interest rates on hold. While both central banks have issued stern words about the need for caution and said that further rate rises remain a possibility, investors are starting to turn their attention to the timing of potential rate cuts.
Opinion varies considerably. At the moment, the Fed’s ‘dot plot’ is suggesting that two rate cuts are likely in 2024, bringing the Federal Funds rates to around 5.1% by the end of the year. This is two fewer than the four indicated during the last update in June.
The Bank of England has resisted giving any predictions on likely rate cuts, saying in the minutes of its recent meeting that they should stay at 5.25% “until material progress had been made in returning inflation to the 2% target sustainably”. The market believes rates will be at around 4.9% by the end of 2024.
Steven Bell, chief economist at Columbia Threadneedle, says: “Central banks have said rate cuts will happen, but only when they feel that inflation is moving sustainably to the 2% target. The question is when that will be.”
He believes interest rate cuts in the US may start early next year, with the UK and Eurozone following shortly afterwards, adding: “That would constitute a very pleasant surprise for the markets, which are pricing in rates to be at or above their current level well into 2024.”
His optimism stems from the view that the interest rate rises already experienced are not yet fully reflected in economic data. In particular, he sees employment data weakening, which is likely to change central banks’ hawkish stance: “We are currently close to or below record employment levels in the US, Eurozone and UK with inflation above target. This makes it easy for central banks to talk tough. However, unemployment is set to rise in all three areas. The US arguably has the best fundamentals, but even here, employment growth has been slowing. In the UK, the uptrend in unemployment seems to be well-established…Rate cuts are coming and they should be significant, bigger than those reflected in markets.”
However, his view is not universal. Alec Cutler, manager of Orbis Global Equity, is far more sceptical that inflationary pressures have eased sufficiently to allow rate cuts to happen. He says: “Everyone is becoming relaxed about inflation. But from our analysis, it’s not going to hit 2% consistently. It may go to 2% for a while, but it’s going to go straight back up. We’re seeing the warning shot with oil.”
Rising oil prices helped send the US’s latest CPI figure higher. It rose 3.7% year-on-year in August, compared to a rise of 3.2% year on year in July. OPEC has been cutting production to keep oil prices higher, particularly as Saudi Arabia now has an ambitious economic diversification programme that requires oil prices at a certain level.
Cutler says that there are a range of inflationary pressures that will continue to weigh on central bank decision-making: “After 40 years of declining labour power, labour is coming back. That will be inflationary. The Berlin Wall fell in 1989, so we had a peace dividend. All the money that used to go to unproductive defence went to other more productive areas. That’s reversing. Then we’ve added the war on carbon, which is a totally new inflationary impulse. Everyone is discounting these things, but when we add them in, we get inflation levels of around 4%.”
If it pans out this way, it is vanishingly unlikely that the Federal Reserve will cut rates as the market currently expects. It may even raise rates again, though this is less certain. Cutler adds: “As soon as the US goes into recession, the political pressure will be immense for the Fed, but a recession doesn’t necessarily mean inflation goes down.”
The Federal Reserve will be under significant pressure in both directions, but on balance, he believes it will not be pushed into rate cuts if inflationary pressures re-emerge.
Strong US consumer
On a recent research trip, the Rathbones US team reported significant strength in the US economy and an insensitivity for many businesses to rate rises.
Will McIntosh-Whyte, manager of the Rathbone Greenbank multi asset portfolios, added: “It did not feel to us that any business we saw had had any kind of negatives impact from higher rates, with the exception of one housebuilder. There were no companies talking about recession, few talking about the consumer reining in spending. They were talking about a strong consumer, a strong outlook for their businesses.”
McIntosh-Whyte attributed this to the amount of fiscal support provided by the Chips and Science Act and the Inflation Reduction Act. He points out that the US is looking to develop its strategic infrastructure and ensure it is robust.
He adds: “It has been creaking for a long time. It is not just building bridges and roads, but encouraging businesses to invest in the US, while also reducing dependence on unfriendly powers, such as China.” This is also likely to put pressure on inflation.
Nevertheless, he is closer to Bell’s view on the employment market. He says: “Company management is scarred around jobs. It’s been so difficult to hire people that companies have often over-hired.” This, he believes, may have kept the job market artificially strong. This is starting to turn with some job losses in the technology space, for Walmart and McDonalds. “There is an element of normality returning.”
He also believes that rate rises are yet to have their full impact on the economy. “Rates have moved very quickly from zero to a high level and that takes time to feed through. They were only 1% in June last year – rates have only been high for 12 months.”
Rate cuts in 2024 are plausible, particularly if the jobs market continues to weaken. However, investors shouldn’t count on them. There are a lot of factors that could push up inflation from here, making rate cuts more difficult for central banks.