Key Takeaways
- Comments from Jay Powell – head of the Federal Reserve – signalled a shift in tone. A cut in US rates could be weeks away.
- US consumer expenditure data will be watched closely – if it moves as expected then a March cut in US rates is likely.
- We may see a near term uptick in Eurozone inflation, but the broader trend is downwards – that means the ECB could follow the Federal Reserve and cut rates soon.
- The UK is further behind, and the Bank of England will need to see a sustained fall in wage inflation.
Markets were thrilled by last week’s remarks from Jay Powell, the head of the US Federal Reserve, which suggested that US interest rate cuts could be just a few weeks away. That’s a big change in tone and a pivot away from the previous policy of ‘higher for longer’. Expectations of rate cuts improved as a result in the UK and eurozone too. So how far will the cuts go in 2024?
What Jay Powell said was that rate cuts could occur before inflation hits the 2% target. The target is set in terms of the year-on-year change in the personal consumers expenditure (PCE Deflator), rather the more familiar CPI. The PCE is out this week, and a low number is expected. Our best guess is that PCE inflation will fall below 2.5% in January and stay there over the following 3 months. Given that figures are released with a one-month lag and that the Fed will want to see more than one month’s data, everything points to the first cut taking place at the 20 March 2024 meeting. A 25 bps cut by then is 83% priced in by the markets. Thereafter markets see further cuts with a total of 150 bps by this time next year.
That’s a lot and markets have been disappointed before when they have moved ahead of the Fed, who tell us to expect a slower pace of reduction. But I am optimistic and expect deeper cuts. Even if the market is correct, that would still leave rates just under 4% by end 2024. Yet the Fed’s own estimate, based of many teams of talented economists, is that the longer-term rate for Fed funds should be more like 2.5%. The war against inflation is not over but the enemy is in retreat and a sustained move back to target is the most plausible outcome. And that means rates well below 4%.
US Core consumer price index (excludes food and energy) % year-on-year increase
When it comes to the eurozone, we can be heartened by the recent big fall in inflation. The Eurozone economy is also much weaker than the US which should put further downward pressure on prices and wages. But near term forecasts suggest that inflation will edge higher in the Eurozone and there are few signs of wage inflation declining, in contrast to the US. Now there is indeed a scenario that eurozone inflation continues to fall and that the spring 2024 wage round delivers much lower numbers. That is a view I share. That would allow the ECB to match the US in terms of scale and timing of rate cuts. But that scenario involves much more forecasting than we need for the US and one thing we have learned about forecasting – if we didn’t know it already – is that it is a hazardous and uncertain business.
As for the UK we are much further from our 2% target either in terms of the CPI or the level of wage inflation that would be consistent with that target. There is some evidence that while the year-on-year rate of wage inflation is high, the sequential month-on-month numbers have tumbled. If that were to be sustained, wage inflation would collapse in the first half of next year and CPI inflation should fall too. But a move sustainably to the 2% target still seems some distance away. The recent improvement in data, which suggests the UK economy is moving ahead of Europe would encourage the Bank of England (BoE) to delay their first cut.
So, interest rates look set to fall in March in the US and there is a good chance that the European Central Bank will follow suit. The UK economy might surprise us with much lower inflation too and allow the BoE to keep up.
