Fed Rate-Cut Timing: More Patience Is Required

As expected, the Federal Open Market Committee decided to keep its key interest rate, the federal funds rate, unchanged at 5.25–5.50%. We believe the Federal Reserve (Fed) won’t cut rates until it sees weakening in prices and labor market data—probably not before fall.

Progress on inflation stalled over the past three months. Despite a decline in the Personal Consumption Expenditures Price Index—the Fed’s preferred price indicator—inflation’s momentum has been upward recently. Also, higher-frequency price survey data show continued pressure from service prices while capital goods deflation has flattened out. For now, a stabilization of inflation around 3% seems very likely to us if the labor market and wider economy don’t weaken. Growth has weakened somewhat, as indicated by U.S. gross domestic product’s 1.6% growth rate in the first quarter of 2024 compared with its 3.4% rate the previous quarter. Despite the quarterly slowdown, however, U.S. growth overall remains robust. For the time being, the Fed appears it will be comfortable staying on hold, reducing its balance sheet at a slower pace over time, and keeping rate cuts for when they’re really needed.

In addition to the fact that core goods’ deflationary impact on U.S. inflation is currently stalled, the positive base effects from 2023’s falling energy prices will wash out now. Service prices, which represent the largest driver of current inflation, have stabilized over the past three months after dropping meaningfully last year. The good news is that inflation’s breadth (how many goods and services are increasing at the same time) is coming down further. However, inflation’s persistence (how sticky inflation will be) has reaccelerated again. As a consequence, the short-term interest rate market has readjusted and is now more pessimistic on rate cuts: Compared with the Fed’s estimate of three rate cuts in 2024, the market—which originally anticipated five 2024 rate cuts—now expects just one.

Our base case is for the Fed to hold until inflation and growth data weaken enough to justify less restrictive monetary policy. These conditions should be met by late in the third quarter of this year. By then, we expect the Fed will be ready to cautiously start easing to support economic growth.

We continue to favor bonds, which benefit from moderating growth and moderating inflation―particularly internationally. We also continue to like equities. Despite a short-term struggle, earnings and guidance have remained robust and any relief from perceived looser monetary policy would likely support equity prices in the medium term.