Following the recent short-term correction across international equity markets and the subsequent sharp rebound, with the S&P 500 index now just minimally below the all-time high registered in mid-July, the main focus of attention last week was the speech by Federal Reserve (Fed) chairman Jerome Powell at the annual Jackson Hole Economic Policy Symposium.
In his highly anticipated speech, Powell said “the time has come” to start cutting interest rates. He also stated that “confidence has grown that inflation is on a sustainable path back to 2%”, after rising to about 7% during the COVID-19 pandemic. Powell also commented that the upside risks to inflation have diminished.
The Fed chairman was unequivocal that “the direction of travel is clear”, adding that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks”.
Meanwhile, he also said a slowdown in the labour market is “unmistakable” and “the downside risks to employment have increased.” He said the Fed “will do everything we can to support a strong labour market as we make further progress toward price stability”.
The Fed chairman’s emphasis on protecting the labour market raises the chance of a bigger cut in rates
Powell acknowledged recent softness in the labour market and said the Fed does not “seek or welcome further cooling in labour market conditions”. In numerous recent articles on this important event, a number of market commentators claimed this statement was the most important part of his speech.
Essentially, the Fed has two goals – to maintain stable prices and to maximise employment. It is always delicate to balance the two. If a central bank waits too long to lower interest rates, the higher borrowing costs may negatively impact economic performance and the labour market.
With inflation now within reach of the central bank’s 2% target, the Fed’s priority is to stop the labour market from deteriorating further via the stimulus lower interest rates can bring.
Most analysts currently forecast that the Fed will begin monetary policy easing measures with a reduction of 25 basis points (0.25 percentage points) in the Federal funds rate at its upcoming meeting on September 17 and 18, from the current range between 5.25% and 5.50%. This would mean the Fed is beginning a new interest rate cycle more than two and a half years after it started hiking borrowing costs to stem the surge in inflation following the pandemic.
But the Fed chairman’s recent emphasis on protecting the labour market raises the chance of a bigger cut in interest rates, especially if the upcoming jobs report for August, due for release on September 6, shows further deterioration after the July employment figures. Earlier this month, the weaker-than-expected July jobs report rattled markets as it revealed that just 114,000 jobs were added to the economy last month, with the unemployment rate rising to 4.3%, the highest since October 2021.
Powell was not specific about the potential pace of future cuts in interest rates or on the possible extent of the envisaged decline in the Federal funds rate. Money markets currently indicate that the Federal funds rate will be within the range of 3.00% to 3.25% by the end of 2025, a decline of more than two percentage points (200 basis points) from current levels.
After the upcoming Fed monetary policy meeting in mid-September, there are a further two meetings this year scheduled for November 7 and December 18. The consensus view is that Fed policymakers are more likely to start with a cut of 25 basis points in September, leaving open the possibility of a larger move if broader labour market conditions deteriorate rapidly thereafter.
The upcoming US interest rate cuts would align the Fed with many of its peers, which have also eased monetary conditions as inflation has fallen across developed economies. The European Central Bank lowered its key deposit rate by 25 basis points in June to 3.75%, and maintained this level at its most recent meeting in July. But the ECB is expected to undertake a further two additional cuts of 25 basis points each until the end of the year, bringing its key deposit rate to 3.25%.
In the UK, the Bank of England (BoE) also reduced its policy rate in August, although Governor Andrew Bailey gave clear indications against the idea of a series of further cuts in the immediate term.
The current environment of two of the major central banks already reducing interest rates and the Fed following in their footsteps imminently marks a new cycle in the interest rate environment following the sharp upturn in rates between 2022 and 2023. There is still a lot of uncertainty on the pace of future cuts in rates by all three central banks and the widespread view that rates will not go down to the historically low levels investors became accustomed to for a number of years before 2022. Only a few days ago, one of the most prominent US investment banks indicated that the Fed is likely to reduce interest rates by 150 basis points within the next 12 months, the ECB by 125 basis points and the BoE by 100 basis points.
In previous cycles of interest rate reductions by the Fed, statistics dating back to 1989 indicate that, as long as the economy did not enter a recession, the S&P 500 index gained at least 11% within 12 months of the first interest rate cut. But when the US economy entered a recession in the following 12 months, the S&P 500 fell by at least 14% over the next year.
Meanwhile, for bond investors, the changing interest rate environment should translate into higher bond prices (and lower yields). This would be positive for those investors already invested in such fixed-income securities. But for investors sitting on idle cash or using treasury management options for their current needs could end up finding it increasingly difficult to continue to achieve those returns going forward or investing in medium- to long-term bonds at lower yields than those currently prevailing.
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