Source: Finance Association
① Today, the market expects to cut interest rates only once this year, and the first drop has been postponed until September; ② According to analysts, the May meeting of the Federal Reserve will be “similar”, which is not necessarily a bad thing; ③ Analysts believe that the 1995 easing cycle was a good model, but today's situation is not at all the same.
This week, the Federal Reserve is about to make an interest rate decision in a very different context from a few months ago.
At a time when the latest data shows that inflation is still stubborn, the financial market is rapidly lowering expectations for interest rate cuts this year. At the beginning of the year, the market generally expected to cut interest rates 6 times this year, with the first drop occurring in March. However, the US inflation data “poured cold water” one after another. Currently, the market expects to cut interest rates only once this year, and the first drop has been delayed until September.
Over the past week, new data showed that the market suffered an unfortunate double blow: gross domestic product (GDP) growth slowed, while the Federal Reserve's favorite measure of inflation was unexpectedly high. Now, investors are preparing for the possibility — the first rate cut will have to be postponed until the end of this year, and possibly until next year.
James Ragan, head of wealth management research at DA Davidson, said the GDP data released last Thursday “will definitely destroy Goldilocks's hypothesis. The combination of slowing growth and rising inflation is not an ideal outcome.”
There should be no surprises at the May meeting
According to Sam Rines, a macro strategist at WisdomTree Investments (WisdomTree Investments), the May meeting of the Federal Reserve will be “much the same,” which is not necessarily a bad thing. “I think the FOMC will be very happy with the current situation because it gives them a choice,” he explained.
The Federal Reserve has always insisted that it needs to have “greater confidence” that inflation is improving before considering easing policies. But Rines said so far, “little data has given them extra confidence.”
He believes that the message conveyed by the Federal Reserve imagines the market at the May meeting is, “If the economic situation requires it, reserve the option to cut interest rates. But we also need to maintain this expectation that they will not cut interest rates drastically until at least the end of 2024 to 2025.”
Preston Caldwell, chief US economist at Morningstar, said, “The latest data means that healthy inflation data will be needed for a longer period of time before the Federal Reserve can rest assured of cutting interest rates.”
Was it repeated in 1995?
Market observers have compared the current situation to the easing cycle in 1995, and believe that it is possible to get a glimpse of the Fed's next move. The Federal Reserve cut interest rates by only 75 basis points that year, which is lower than expected to cut interest rates by more than 100 basis points.
Jim Caron, chief investment officer of the portfolio solutions division at Morgan Stanley Investment Management, said, “This comparison is certainly appropriate.”
He explained that in 1994, “the Federal Reserve raised interest rates sharply from a very low base. Since then, the central bank kept interest rates stable until mid-1995.” Then, the Federal Reserve cut interest rates three times in July, December, and January 1996, respectively, and then stayed on hold until raising interest rates again in 1997. The next cycle of interest rate cuts began in the fall of 1998.
Former Federal Reserve Vice Chairman Richard Clarida (Richard Clarida) once pointed out that the two interest rate cuts in 1995 and 1998 were an insurance measure for the Federal Reserve against economic weakening, even though it saw no signs of a recession at the time. Some Federal Reserve observers believe that 1995 is a more appropriate template for the current situation.
Ragan said that one reason why the 90s cycle resonates today is, “This is the only time the Fed has entered a cycle of cutting interest rates, but there has been no recession.”
differences
Analysts say that although the 1995 cycle is similar to the current cycle, it is not entirely similar.
Caron explained, “The problem with this historical comparison is that the catalyst for events at the time was completely different. The inflation story of the past two years is unique in history, driven by a once-in-a-century pandemic and the federal government injecting large amounts of money into the economy.”
Rines said, “This is a different economy; this is a different inflationary shock. In the last cycle, due to the slowdown in GDP growth, inflation was quite stable, and the Federal Reserve had room to adjust without causing any losses. But today, even with an adjustment of 25 basis points, the cost is much higher.”
“The central bank cannot risk driving up inflation, let alone any unexpected move could cause waves in the financial markets.” he added.
Investors' basic expectations
Seen this way, even looking back at 1995 doesn't tell us exactly where the Federal Reserve will go this year, but Caron believes investors can still keep in mind a lesson: “It's not unheard of (the Federal Reserve) not to cut interest rates for a year.”
Sticky inflation shouldn't worry long-term investors that much either. Analysts said, “In a period where the Federal Reserve has been taking measures against inflation for some time and has achieved considerable success, this situation is not unusual.”
“With interest rates rising, the market performed very well.” Rines added, “Inflation has declined and now it just needs to be further reduced. The Federal Reserve will then normalize interest rates and our economy will continue to grow.”
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