The Fed cuts interest rates, will the excitement continue? Or will it actually move?

1. Powell will continue to wait, market expectations once again

Regarding the expectation of a Fed rate cut, between the middle of this year and the end of the year, Powell has not provided clear information yet. However, the market is always keen on various speculations and speculative investments. Market participants are betting based on their own interpretations and predictions, hoping to gain an advantage in this smokeless battle.

At the end of last year (2023), Fed Chairman Powell and his team members expressed a clear outlook - if the significant downward trend in inflation in the second half of last year (2023) can continue, then they are very likely to implement a rate cut strategy in the middle of this year (2024). This expectation was further reinforced when Powell testified before Congress in March this year, when he bluntly stated that the Fed is "close to having the full confidence needed to cut rates".

However, with the rebound in first-quarter inflation data and the robust economic performance, the original reasons for a rate cut, like a sandcastle on the beach, gradually collapsed under the onslaught of the storm. This dramatic shift not only highlights the complexity and unpredictability of economic forecasts but also once again confirms the Fed's caution and prudence in monetary policy making. Powell stated that the first-quarter data "do not support" a more confident view of the inflation path, and more good data is needed to enhance confidence, leading to market expectations and traders' judgments swinging. They have to continuously adjust their expectations and timetables for rate cuts based on the new economic dynamics.

It is worth noting that although the market craves clear answers, Powell did not give a direct response in his public remarks. Powell chose to wait. Based on the voices at the end of last year, the Fed is expected to wait for the accumulation of economic data for about 3-6 months, gradually verifying or refuting the possibility of a rate cut based on the data. This strategy reflects the Fed's commitment to a data-driven decision-making process and also demonstrates its caution and prudence in major policy decisions.

I believe the current Fed is in a neutral position, with the risks in the labor market and high inflation basically balanced. The current Fed's statements are increasingly inclined towards maintaining a low unemployment rate while achieving full price stability, essentially expecting a soft landing, ensuring that inflation returns to the Fed's 2% target and preventing a surge in layoffs, striking a balance between the two. The biggest difference compared to before can be said to be the transition from overheating to cooling down.It should be whether to further raise interest rates or stay put, and whether it is possible to achieve a mild soft balance of no change or rate cuts by now.

Because this means that the higher the possibility of "soft balance" now, the less likely there will be a larger interest rate cut, and the overall nominal interest rate level space and even the neutral interest rate may be raised. Monetary policy is restrictive, but not excessively restrictive. I have expressed a similar view before: the current global political cycle, Western demographic cycle, industrial revolution, and technological cycle may have already affected the long-term growth efficiency and neutral interest rate level behind. Of course, such judgments are definitely a bit unconvincing for most people, often only more evidence can be obtained after walking out.

Second, data will become more and more important from now on.

The federal funds rate is at a "currently appropriate policy level," allowing the Fed to balance the risks of disrupting the strong job market due to premature or late rate cuts. Powell also expressed hope to see a slowdown in demand pace, with solid data support to make him "confident that the inflation rate will gradually fall to 2% by mid or end of next year within the 12-month forecast period." However, it must be emphasized that he will not make any predictions or give any clear signals about any specific date or the outcome of any meeting.

As for when we can find conditions to allow rate cuts, this is indeed a question that needs careful consideration. This process may require months of careful consideration, and may even require patience for several quarters to ensure that the Fed's decisions are based on sufficient market data and robust economic analysis.

When the Fed needs to make a decision, it will make decisions based on data, future data, evolving outlooks, and risk balances, rather than considering other factors, including political factors," Powell said at a hearing of the House Financial Services Committee. "We have been doing this for a long time, including in election years, this is the commitment we will make... Everything we do will be based on solid grounds. For us, considering the election cycle is inappropriate, in any case, it is inappropriate. Starting now, due to the first-quarter data not meeting expectations and the data in the first half of the second quarter not enough to support a change in the Fed, so after this statement, the subsequent data will become more and more important, and market fluctuations will increase with changes in data;

The unemployment rate in June has risen from 3.7% at the end of last year to 4.1%, mainly because the pace of hiring has slowed down, and new workers or workers re-entering the labor market take longer to find jobs. The problem is not significant at the moment because companies are not laying off workers on a large scale, and the layoff rate remains low. Meanwhile, in the past two years, the arrival of immigrants has increased the labor supply, but in the coming months, the number of immigrants may decrease, leading to a possible drop in the unemployment rate again. Nominal wage growth still remains resilient, with average hourly wages in June growing by 3.9% year-on-year;

It is important to note that there is a certain seasonal bias in the second-quarter employment data. Initial claims data include Independence Day holidays, and typically fluctuations in the number of unemployment claims are often seen around holidays. Automobile manufacturers usually shut down assembly plants in the week starting from July 4th to adjust equipment for producing new car models, which introduces volatility to the data, making it difficult to make accurate judgments on the labor market during this period.

Overall CPI was dragged down by a 3.8% decrease in gasoline prices, with gasoline prices falling by 3.6% in May. Housing costs, including rent, rose by 0.2% after a 0.4% increase in May. The current supply and demand balance in the oil market limits the downward price movement. The gradual stabilization of the global economy and geopolitical uncertainties provide some support for oil prices. Additionally, the production cut agreement among OPEC+ members continues to limit the downside of oil prices. Current oil prices are within a reasonable range as geopolitical tensions in the market gradually rationalize.

However, the continuous downward trend in the US CPI energy component may soon face a change, possibly stabilizing or even experiencing a seasonal rebound in the coming months. On one hand, the current supply and demand balance in the oil market limits the downward price movement; on the other hand, the low levels of gasoline inventories may exert seasonal upward pressure on prices in the future. If the peak consumption season and seasonal destocking, combined with any supply interruptions or refinery maintenance in the Gulf region, further exacerbate inventory tightness, it could drive up gasoline prices, reversing the downward trend in commodity inflation

Three, No Rabbit, No Eagle

Although the June CPI data has had a good start, to achieve a rate cut in September, more convincing employment and inflation conditions in July and August must be confirmed. It is premature to judge a rate cut in September based solely on current data.

Based on the continuous changes in data over a period of time, the Fed may signal when to start cutting rates, preparing the market for the next steps.

Powell's comments on making decisions at each meeting seem to rule out the possibility of a rate cut at the next meeting. He believes that a rate cut in September is not as certain as currently reflected in financial markets.

At least another quarter of continuous data decline is needed to have an impact on future 12-month inflation expectations. Only then will the Fed possibly take action at the end of the year. If Q3 data still show that short-term variables are affecting the data, and the data fluctuates, the Fed may still remain inactive throughout the year, leaving only the heart to move.

So, the market's bias may not be on whether the Fed will raise or cut rates, but rather: because there is no possibility of a rate hike, the only option is the market's excessive anticipation of rate cuts, and the discovery that this expectation may be continuously postponed leading to fluctuations in expectation differentials.

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