Expectations for the Federal Reserve to cut interest rates are rising again, and we still need to be wary of the risk of reflation in the future

As economic data releases more anti-inflation progress, expectations for the Federal Reserve to cut interest rates have once again increased.

After the U.S. PPI unexpectedly shrank in December last year, the market once again increased its bets on the Federal Reserve cutting interest rates early this year, and U.S. bond yields fell. Last week, the 2-year U.S. Treasury yield, which is highly correlated with the Fed's interest rate expectations, fell 13.1 basis points, recording the largest weekly drop in a month. On January 15, the 2-year U.S. Treasury yield hovered around 4.14%, well below the previous high of 5.26%.

Zhao Wei, chief economist of China International Finance Securities, told a reporter from the 21st Century Business Herald that interest rate cuts have been the main line of overseas transactions since early November 2023. The three major factors of the recent U.S. economic fundamentals, fiscal refinancing and the Federal Reserve's policy stance have all emerged. There has been a change: the U.S. manufacturing PMI weakened, and GDP growth slowed in the fourth quarter of last year; the U.S. Treasury Department revised down the financing scale for the fourth quarter at its regular refinancing meeting in the fourth quarter last year, and lowered the net issuance scale of long-term government bonds; the Federal Reserve turned dovish, The regular meeting in December last year confirmed that the issue of interest rate cuts would be discussed and expanded the space for interest rate cuts in 2024.

It is foreseeable that under the data-dependent model, the game around interest rate cuts will continue, and everything is still uncertain.

Positive inflation boosts interest rate cut expectations

Behind the recent fall in U.S. bond yields again, falling inflation is the key reason.

U.S. producer prices unexpectedly fell in December due to falling costs for commodities such as diesel and food, suggesting that inflation may continue to fall and provide grounds for the Federal Reserve to begin cutting interest rates this year. Data from the U.S. Department of Labor showed that the U.S. PPI increased by 1% year-on-year in December last year, lower than the expected 1.3%; month-on-month, the PPI shrank by 0.1%, also lower than the expected growth of 0.1%, with zero or negative growth for three consecutive months. .

Excluding volatile food and energy, core PPI increased by 1.8% year-on-year in December last year, lower than the 2% expected, and slower than the 2% increase in November last year, the smallest increase since the end of 2020. Core PPI increased 0% month-on-month, lower than the 0.2% expected, consistent with November last year and remaining unchanged for three consecutive months.

Barclays economists Marc Giannoni and Jonathan Millar predict that given recent progress in inflation, we believe the Fed will feel comfortable cutting interest rates without seeing significant weakness in the economy or labor market. The Fed will begin easing policy earlier, with its first rate cut expected in March rather than June.

In contrast, the performance of the consumer price index has lagged. In December 2023, the CPI increased by 0.3% month-on-month and 3.4% year-on-year, exceeding market expectations and higher than November last year. The core CPI, which excludes unstable factors such as fuel and food, increased by 3.9% year-on-year, the lowest since May 2021, but higher than market expectations of 3.8% and a month-on-month increase of 0.3%, consistent with market expectations.

Although the CPI data is slightly higher than expected, there is no overall trend change and is unlikely to change the Fed's policy outlook this year. CPI data in the next few months may have a greater impact on the timing of the Fed's first interest rate cut.

The fall in inflation expectations also helps the Fed fight inflation. A survey recently released by the New York Fed showed that consumers' inflation expectations for the next year have dropped to a three-year low, with inflation expectations in December falling to 3.01% from 3.36% in November last year.

In Zhao Wei's view, the de-inflation process in the United States is relatively smooth, and there is still room for it. The risk of reflation in the short term is low. Although it is difficult to say victory, it can be said that victory is in sight. The main task of the "second half" of de-inflation is core inflation, with the main contributions being rent inflation linked to house prices and wage growth linked to broader services inflation. Based on the leading relationship between house prices and rental inflation, the downward trend in rental inflation is expected to continue into the third quarter of 2024. Whether the downward trend in wage growth can continue is the key to the smoothness of the service de-inflation process.

Be wary of reflation risks

Although recent economic data supports the Federal Reserve's interest rate cuts this year, the market's 150 basis point interest rate cut expectations may still be too aggressive.

John Canavan, a U.S. analyst at Oxford Economics, told a reporter from the 21st Century Business Herald that the market expects the Federal Reserve to cut interest rates significantly ahead of schedule this year, but it may have gone too far. The Fed's first interest rate cut is expected to occur in May, with interest rates cut by 75 basis points this year. If the market adjusts in the direction we expect, U.S. bond yields should be pushed higher in the short term.

The risk of future reflation cannot be ignored. Zhao Wei analyzed that in the context of a soft landing of the economy and interest rate cuts by the Federal Reserve, the tighter the labor market, the greater the risk of reflation. This time it is indeed possible to see a situation like the 1960s or the mid- or late 1990s: after cutting interest rates for a period of time, the U.S. economy may face the risk of reflation, which will limit the Fed's space for further interest rate cuts, and may even trigger the Fed to raise interest rates again.

One "tail risk" that the market is worried about is: if the U.S. economy has a "soft landing," the risk of reflation in 2024 may once again exceed expectations, which will prompt the Federal Reserve to raise interest rates again and the capital market to "double kill stocks and bonds." But Zhao Wei said that based on experience, reflation risks in the context of a soft economic landing tend to appear after the Federal Reserve cuts interest rates, not before. The view that the Fed is not in a position to cut interest rates due to concerns about reflation may reverse cause and effect. Therefore, reflation risk affects the space for interest rate cuts, not whether interest rates will be cut.

For the Federal Reserve itself, high interest rates have already caused a considerable impact. In mid-January, the Federal Reserve released its unaudited preliminary financial statements for 2023. As it vigorously supported the economy during the COVID-19 epidemic and then aggressively raised interest rates to combat high inflation, the Federal Reserve's operating losses last year reached a record high of $114.3 billion. By comparison, the profit in 2022 is US$58.8 billion.

As one of the ways to implement monetary policy and control short-term interest rates, the Federal Reserve pays interest to banks, financial companies, and other qualified money managers. Affected by the sharp increase in interest rates, the Federal Reserve paid $281.1 billion to financial institutions last year, compared with only $102.4 billion in 2022. When the Fed returns to profitability depends on the timing and speed of rate cuts.

Will remain on hold in the short term

Judging from various signs, there is no need for the Federal Reserve to urgently cut interest rates.

U.S. Department of Labor data shows that the U.S. unemployment rate was 3.7% in December last year, only 0.1 percentage points higher than when the Federal Reserve began raising interest rates in March 2022. The Fed needs to balance its dual mission: stabilizing prices and maximizing employment. Given that the job market remains resilient and price pressures remain high, the Fed's current policy considerations are mainly to push inflation back to its 2% target.

Officially, Atlanta Fed President Bostic said the Fed needs to stay on hold until at least this summer to prevent prices from rising again. If policymakers cut interest rates too early, inflation could "wobble." He also warned that the fall in U.S. inflation toward the 2% target may slow in the coming months. By the end of 2024, the inflation rate is still likely to remain around 2.5%, and it will not fall back to the 2% target set by the Federal Reserve until 2025.

Bostic also reminded that due to the situation in the Red Sea, shipping costs have soared recently, and this needs to be "closely monitored." The cost of shipping a 40-foot standard container from the Far East to Europe has surged nearly 150% in the past month, according to logistics research firm Xeneta.

Echoing this, Chicago Fed President Goolsby also said that inflation will cool down in 2023 and the overall performance will be good. As long as this trend continues, it will pave the way for an interest rate cut in 2024. In the future, we need to see more data confirming that recent price pressures continue to ease before we can judge how fast the rate cut should be.

Looking ahead, investors still need to be wary of changes in interest rate cut expectations impacting the market. Zhao Wei analyzed that the Federal Reserve adopted a "strategic ambiguity" strategy in its expected guidance: on the one hand, it began to discuss the issue of interest rate cuts, and on the other hand, it retained the possibility of further tightening policy. Ultimately, whether interest rate cut expectations come true depends on inflation trends. The number of interest rate cuts priced in the futures market deviates from the Federal Reserve's summary of economic forecasts, and there is a risk of correction in the short term.