The first cut is the hardest

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The narrative has recently shifted from only questioning how brutal the US recession was going to be — and whether it had already started — to “no landing”, as employment, spending etc have stayed remarkably strong.

But with inflation softening some people think the Federal Reserve will still have to trim interest rates soon so that they aren’t unduly restrictive, whether a recession materialises or not. Lo and behold, Goldman Sachs — a noted bull — has now pencilled in the first Fed cut for the second quarter of 2024.

Its economics team reckons that the core personal consumption expenditures inflation rate (the Fed’s own fave measure) will by then have fallen below 3 per cent on a year-on-year basis and under 2.5 per cent on a monthly annualised basis, which will be enough to give the Fed cover. “The motivation for cutting outside of a recession would be to normalise the funds rate from a restrictive level back towards neutral once inflation is closer to the target,” they write.

However, the details of the report indicate that their confidence in this call is pretty modest. Here are the main points, with Alphaville’s emphasis below:

— Normalization is not a particularly urgent motivation for cutting, and for that reason we also see a significant risk that the FOMC will instead hold steady. The FOMC might not cut because inflation might not fall enough or, even if it does, because solid growth, a tight labor market, and a further easing of financial conditions might make cutting seem like an unnecessary risk.

— Some Fed officials and investors argue that the FOMC must cut as inflation falls to prevent real interest rates from rising and hurting the economy. We disagree with this logic. Real interest rates should be calculated by subtracting off forward-looking inflation expectations, not realized inflation, and inflation expectations have already fallen to or nearly to target-consistent levels. Moreover, adjusting our broader financial conditions index (FCI) for inflation rather than the funds rate has very little impact on the implied impulse to GDP growth, which is now modest.

— We are penciling in 25bp of cuts per quarter but are uncertain about the pace. The FOMC might move slowly if its desire to normalise is only lukewarm and it fears further boosting asset prices and strengthening an economy with an already-tight labor market, or it could cut more quickly from a high starting point if it is more confident that the inflation problem is unlikely to return.

— We expect the funds rate to eventually stabilize at 3-3.25%, above the FOMC’s 2.5% median longer run dot. We have long been skeptical that neutral was as low as widely thought last cycle, and larger fiscal deficits have arguably pushed it higher since. Fed officials could raise their longer run dots if the economy remains resilient with the funds rate at a much higher level or they could conclude — as a recent New York Fed blog post did — that the short-run neutral rate is elevated.

— Our views have been more hawkish than market pricing this year because we have seen both a lower probability of recession than consensus and a relatively high threshold for rate cuts. This remains true, though the gap has narrowed as recessions fears have faded. We think it is appropriate for the yield curve to be inverted, but not quite as much as it is.

Here is that NY Fed paper that Hatzius mentions above btw, and you can read the full Goldman Sachs report here.

FWIW an extended wait-and-see period followed by a gentle interest rate trim kinda makes sense given the current trajectory of inflation. But trajectories change. Who knows what could happen in the world between now and then.

And the Fed’s perennial worries about its credibility — and the perceived damage done by the “transitory” snafu — makes us think that absent a big economic downturn it’s going to want to see inflation much closer to or even below 2 per cent before it dares to actually cut rates.