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The Fed Has Finally Begun Raising Interest Rates. Here’s When It Will Start to Cut.

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The Fed is battling inflation. Gasoline prices are a big part of the problem.

Joe Raedle/Getty Images

Financial markets deserve their reputation for focusing on the future.

Investors are looking past the likelihood that the Federal Reserve will lift interest rates repeatedly over the next couple of years. Markets are already forecasting the central bank will then cut rates as the economy cools down.

When the Fed implemented its first rate increase since 2018 in March, it laid out a forecast that implies it would lift the federal-funds rate 11 times in total to fight high inflation. That would send the benchmark lending rate up to 2.75% by some point in 2023. The fed funds futures market, which reflects the probability that the rate will land at certain levels at specific points in time, is also indicating that the figure will hit 2.75% in early 2024, according to


Citigroup
’s
tracking of the futures data.

While news headlines and market commentators focus on how the Fed is in rate-lifting mode—and it is—the fed funds futures market is also signaling that the central bank isn’t too far from lowering borrowing costs again. Prices in the futures market indicate that the Fed will cut rates in late 2024, sending the fed-funds rate down to 2.25%, the equivalent of two quarter-point cuts from the expected peak.

That might sound like a head-scratcher. Why would the Fed cut rates if it has to lower inflation?

The reason is that the coming rate increases are meant to curb demand across the economy and therefore lower inflation. Once the economy is weak enough for inflation to come down, the Fed would shift its focus to cutting rates as it seeks to make sure as many people have jobs as possible.

The bond market is already reflecting that the economy will weaken, which might call for eventual rate cuts. The so-called yield curve has flattened, which means that the yield on two-year Treasury debt is catching up to the 10-year yield.

That is because the two-year yield is reflecting higher short-term interest rates—the result of the Fed’s expected moves—which could reduce economic demand and inflation for the longer term. Expectations for lower inflation in later years limit how high the 10-year yield can go.

If the yield curve inverts, which means the two-year yield is higher than the 10- year yield, it often means a recession is coming within just a couple of years. Many on Wall Street have even flagged that the flattening yield curve—and the potential for disappointing economic data—could stop the Fed from raising rates as many times as currently expected.

The point where economic data significantly weakens is when rate cuts would be in the cards.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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