Contrary to most economists’ expectations but in line with the market’s pricing, the US Federal reserve lowered official interest rates by 50bps, taking the range to 4.75%-5.0%. However, the overall tone was less ‘dovish’ than expected and there was one dissenting vote.
The cut came against a background in which the US economy is still performing well and was positioned as an appropriate recalibration of policy, in which the objective is to return rates to a more neutral stance now that inflation is less of a threat. The ‘dot plots’—the individual forecasts from FOMC participants—show that policymakers see this as the start of a rate-cutting cycle, but not a swift one, with an aim towards neutrality rather than going below it. Taking the plot suggests another 50bps of cuts this year and an additional 100bps next year. Market pricing is more bullish, seeing nearer 200bps of cuts. There was a slight increase in the FOMC’s longer-run rate forecast to 2.9% from 2.8%, with the median forecast reaching that target by 2026.
All this seems logical but there is a feeling that the Fed was bounced into this by more aggressive market expectations. In my view, it is not the case that the US economy needs the lower rates that are now expected. Judged by historical standards, the labour market is tight, corporate earnings are robust and service inflation remains elevated. There may be a case to get a big cut through ahead of the Presidential election, to avoid any controversy nearer the date, but the clamour for a 50bps was led by the market. This may set a bad precedent.
“In my view, it is not the case that the US economy needs the lower rates that are now expected.”
The Bank of England (BoE) chose to keep interest rates at 5.0%, despite pressure for another cut, with only one out of nine MPC members voting for a reduction. The BoE expects gradual rate reductions, projecting inflation will return to target within two years based on a slow decline in rates to 3.50% over three years. I believe that a rate cut remains likely in November when updated forecasts are available, allowing the BoE to reassess economic conditions. The UK data remains difficult to interpret with robust PMI surveys and a declining unemployment rate. Against this, the latest consumer confidence reading saw a big drop in September and monthly GDP data has stagnated. The UK inflation data did not clarify either. As expected, headline CPI remained at 2.2% in August while core CPI increased from 3.3% to 3.6%. Services, again, was the disappointment with inflation rising to 5.6%; the main contributors to the increase in services was higher air fares. More broadly, the components of services inflation show little recent downward movement.
The loss of UK consumer confidence may reflect government messaging ahead of the Budget. It is easy to criticise this downbeat approach but there has been a lack of realism in relation to public finances and a better appreciation of the debt situation is welcome. The problem is that tax increases will need to be targeted to limit the impact on growth potential and the new government’s contribution to the deterioration in public finances through public sector wage settlements has not been contingent on any improvement in productivity. Not a good start for a growth agenda.
There is an adage that it is better to travel than arrive. Last week, government bond markets demonstrated this saying. Despite the 50bps cut in rates US, 10-year treasury yields rose 10bps, ending at 3.75%. This was also reflected in real yields with the 20-year rate rising to 1.9%. In the UK, 10-year gilt yields closed at 3.9%, a rise of 14bps. The rise in real yields was less pronounced, with implied breakeven inflation rising, breaking the recent trend. Credit markets were more enthusiastic about the US rate cut. Sterling spreads nudged lower but there was a more decisive move down in high yield spreads.
The UK’s October Budget remains a major uncertainty and is likely to cloud investors’ perceptions until the details are revealed. How to get growth without triggering inflation remains the exam question. Listening to one investor’s question at a recent conference struck home: where are the workers and building materials going to come from to build 300,000 homes when we are struggling to find them for 230,000?
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