There’s good news and bad news on the U.S. economy.
On a positive note, the labor market continues to attract more workers and create more jobs, keeping unemployment near historic lows, while inflation appears to abate. The bad news is that interest rates are unlikely to decline anywhere near as much as the markets are betting.
That’s likely to mean a better 2024 for Main Street U.S.A. than for Wall Street.
Friday brought news that nonfarm payrolls increased by 199,000 in November, about one-tenth more than economists’ guesses. The big surprise was the drop in the unemployment rate, to 3.7% from 3.9%, and for the right reasons. In the separate survey of households, from which the jobless rate is derived, nearly three-quarters of a million folks found jobs last month, even more than the half-million-plus that entered the labor force.
That good employment data means the Federal Reserve is unlikely to slash interest rates nearly as much as the Grinches in the financial futures and Treasury market had been anticipating. Even though they have trimmed their expectations for where they see the Fed’s key rate in a year, they are likely overestimating the scope of rate reductions.
The Federal Open Market Committee, the central bank’s monetary policy-setting body, will reveal what it thinks after its two-day meeting concluding this Wednesday. While no change in its current federal-funds target range of 5.25%-5.50% is all but certain (actually, a 98.4% probability according to the CME FedWatch tool), the FOMC will outline its best guesses in its Summary of Economic Projections, or SEP, for the coming year and beyond.
This would be the first update in the SEP since September, when the Fed anticipated a median fed-funds rate of 5.6% by the end of this year. The FOMC then looked for two cuts of one-quarter point, to 5.1%, by December 2024.
But as the chart here shows, the futures market anticipates at least four rate cuts by the end of next year. “The market is definitely running ahead of the Fed,” John Ryding, chief economic advisor for Brean Capital and former staff economist for the Fed and Bank of England, told Barron’s.
Although the market dialed back its expectations for rate reductions following the stronger-than-expected jobs report, Ryding adds that Fed Chair Jerome Powell will likely have to push back against market speculation about lowering rates by a full percentage point or more next year. Such a sharp drop would only make sense in an economy in recession, evidence of which seems scant.
Even downbeat consumers surveyed by the University of Michigan recently perked up, largely because they saw inflation abating—all good news to the Fed and, no doubt, the White House.
The widely watched U. Mich. preliminary December consumer sentiment index jumped to 69.4 from 61.3 in November. Most gratifying was their expectation of inflation in the year ahead, falling to 3.1% from 4.5%. Consumers’ assessment of inflation tends to follow closely what they pay at the gas pump, which has fallen about 20 cents a gallon in the past month, according to the latest AAA survey.
Beyond that, Ryding thinks the Fed can take heart from the slowing in its preferred inflation gauge—core personal income expenditures excluding food and energy prices—which has been tracking around 2.5% for the past six months. That consumers see price increases slowing is a major plus for policy makers. The Fed can let time substitute for further rate hikes to bring inflation back to its 2% target, he added.
But in the absence of deterioration in the economy, the scope for easing of rates is limited. Ryding notes that the spread of high-yield bonds over risk-free Treasuries is close to a historic low. Typically that yield premium, which compensates for the risk of speculative-grade debt, widens when the economy takes a downturn, he notes.
All this underscores that the Fed is unlikely to fulfill bond and stock bulls’ hopes for big rate cuts in the year ahead. Those expectations have been major spurs to the rallies in both markets recently.
Ryding thinks the FOMC could project two quarter-point cuts in the median projection in the panel’s so-called dot plot. If he had a vote on the panel, his dot would be for three quarter-point trims, given the slowing in inflation he foresees.
Similarly, J.P. Morgan chief U.S. economist Michael Feroli writes in a client note there are likely two quarter-point cuts implied in the FOMC’s dots for end-2024, which would be a quarter-point below the September median projection of 5.1%. But that remains far above the 4.31% fed-funds rate implied by the December fed-funds futures, even after a 0.18 percentage point increase on Friday following the strong November jobs numbers.
Conversely, the market thinks the long-run fed funds “neutral” equilibrium is well above the 2.5% presumed by the FOMC. Bank of America economists note the market projects the Fed’s key policy rate to be around 4% out in 2026.
All of which is consistent that interest rates will remain higher for longer, as this week’s cover story says. And that goes against the expectations of bond bulls that the Fed will cut rates sharply in the next year. Ryding further suggests that would imply a much weaker economy, something that would batter stock bulls, and definitely wouldn’t be the good news they seek.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
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