The world is paying close attention to every word Federal Reserve Chair Jerome Powell utters after each Fed meeting. Global markets respond to his comments, with investors and traders adjusting their positions based on the Fed's guidance. Trillions of dollars can shift in response to the central bank's actions.
Historically, the Federal Reserve has used "forward guidance" as a tool to shape market expectations regarding the future path of the federal funds rate. On July 31, 2024, when Powell announced that the federal funds rate would remain unchanged at 5.25 per cent-5.50 per cent, the world's focus turned to the Fed's next steps. Powell’s statement that there has been "further progress toward the committee's 2 per cent inflation objective," and a shift in language from saying inflation "remains elevated" to "is somewhat elevated," suggested growing confidence in achieving the inflation target.
Powell also noted that job gains had moderated, and the unemployment rate had increased, though he still described the job market as "solid." The Fed emphasized its dual mandate of low inflation and full employment, signaling a departure from the aggressive rate hikes of the past two years. This was enough to buoy the markets, with equities and fixed-income assets rallying immediately after the Fed's announcement.
However, just days later, the Bureau of Labor Statistics reported a July unemployment rate of 4.3 per cent—the highest since October 2021—and a lower-than-expected payroll gain of 114,000 jobs, compared to economists' forecasts of 175,000. This data sparked fears that the US economy might be weakening, leading to a market correction as concerns about a potential recession grew. It's worth noting that market reactions can be volatile and mood-dependent; the similarly weak April 2024 job creation numbers did not trigger such a response.
Adding to the uncertainty, the Bank of Japan (BoJ) raised interest rates for the second time in 2024 in August, following a March hike—the first in 17 years—as it sought to combat inflation driven by the weakening yen. This move sent the Nikkei into a bear market and reignited concerns about the yen carry trade, where investors borrow in yen to capitalize on low interest rates in Japan and invest elsewhere for higher returns. If these trades unwind, it could lead to significant capital outflows from global markets, raising fears of a repeat financial disruption.
A key question on everyone's mind is why the Fed has not yet reduced rates, and why the next move might not come until September 2024. Powell explained that the Fed wants to see more evidence that inflation is sustainably moving toward 2 per cent before adjusting policy. The Fed is cautious, remembering the aftermath of COVID-19, when it mistakenly believed inflation was transient. The Fed is keen to avoid repeating this policy error and potentially reigniting inflation.
While it's uncertain whether inflation will continue to decline to 2 per cent or settle at a higher level, what is clear is that if interest rates remain elevated for an extended period, the risk of recession increases. Economies and corporations with high debt levels could struggle to borrow and service their obligations, raising the possibility of defaults. In such circumstances, central banks, including the Fed, may need to cut rates more aggressively to prevent a severe economic downturn.
Since mid-2022, both the Fed and the European Central Bank (ECB) have raised interest rates by 525 and 450 basis points, respectively. Given the typical 18–24-month lag between rate hikes and their full impact on economic growth, there is a significant risk that waiting too long to cut rates could lead to a slowdown, increased unemployment, and a potential recession. Powell has acknowledged that the current policy stance is restrictive enough to negatively affect economic activity, with the unemployment rate rising from 3.4 per cent in April 2023 to 4.3 per cent in July 2024. The risks now appear to be skewed toward a weaker economy.
As inflation shows signs of improvement and other economic indicators weaken, the time to cut rates is approaching. Many analysts from major global banks predict multiple rate cuts in 2024, with some even forecasting two 50-basis-point cuts. They estimate a terminal rate of 3.00 per cent to 3.25 per cent by mid-2025, a significant decrease from current levels. However, the economic data will ultimately determine the pace and extent of these cuts. We must remember that Stock market is not just the economy, and the Fed responds to inflation and growth, not the level or volatility of share prices unless it threatens financial stability. Further, the Fed does not respond to pressure from politicians and shall always move cautiously and incrementally avoiding any overdoses of rate cuts.
For months, US economic data has been inconsistent, keeping markets on edge as they await the Fed's next move. The challenge for central banks globally will be to navigate this transition carefully to avoid shocks to the global economy.
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