A flurry of Fed rate cuts may not happen - inflation isn't dead

Expectations of a prolonged interest rate-cut cycle need to be tempered given the presence of several inflationary risk factors.

- Vikram Khanna

Come Sept 18, we will most likely see the first cut in the US Federal Reserve's Fed funds rate since the Covid-19 pandemic in March 2020. Starting in March 2022, Fed raised its benchmark Fed funds rate 11 times, from near zero to 5.33 per cent.

At the annual central bankers' jamboree in Jackson Hole on Aug 23, Fed chairman Jerome Powell sounded the clearest possible signal that rate cuts were imminent. "The time has come for policy to adjust," he said, adding that "the upside risks to inflation have diminished, and the downside risks to employment have increased".

But this diagnosis is subject to caveats and its validity may be more temporary than many market players seem to think.

As supply chains normalised post-Covid-19 and the initial surge of food and energy prices after the Ukraine war dissipated, inflation came down dramatically.

The US consumer price index (CPI) dropped from a high of 9.1 per cent in June 2022 to 2.9 per cent in July 2024. Over the same period, the Fed's preferred inflation measure, the personal consumption expenditures index, fell from a peak of 7.1 per cent to 2.5 per cent, close to the Fed's 2 per cent target.

Meanwhile, unemployment, although still low by historical standards, has been on the rise, reaching 4.3 per cent in July, almost a full percentage point higher than in early 2023 and the highest level since October 2021.

Non-farm payrolls - a key indicator of employment trendsrose by only 114,000 in July, well below market expectations of 175,000.

UNJUSTIFIED EXPECTATIONS

With inflation falling and unemployment on the rise, market players are expecting a spate of interest rate cuts. Futures markets point to a cut of a full percentage point in 2024, followed by another percentage point in the first half of 2025.

But are such exuberant expectations justified? A closer look at the data, plus policy-related and financial risks, suggests they are not.