Allianz Chief: Market's expectations for Fed rate cuts may be too aggressive

This week's inflation data - whether it's producer prices or consumer prices, has played a calming role in two different aspects: confirming continued progress in dealing with rising prices and supporting the Fed's shift of focus from inflation to employment tasks.

This opens the door for a rate cut in September, but does not support the market's pricing of the final interest rate. In fact, the market's pricing of the final interest rate seems too low, with an overpricing of up to 50 basis points.

The producer price data released on Tuesday this week, whether at the overall level or excluding the volatile food and energy categories, was below consensus forecasts. This positive news triggered a sharp rebound in the stock market, and bond yields also significantly declined. Wednesday's consumer price data further validated these market reactions, with the data largely in line with consensus forecasts. The overall CPI in July rose by 2.9% compared to the same period last year, returning to the "2-handle" for the first time since 2021.

Based on these inflation readings, it is almost certain that the Fed will start its rate-cutting cycle in September, most likely by 25 basis points (although a 50 basis point rate cut is also not impossible). At first glance, this supports the market's view that the total rate cut of 200 basis points we are currently seeing will bring the federal funds rate to 3.25%-3.5% in the next 12 months.

To maintain these expectations, this week's data needs to be strengthened in two key areas. First, Powell's speech next week at Jackson Hole must be supportive and comprehensive. This will include clarifying his views on the neutral rate that neither stimulates nor restrains the economy, the path to achieving this target, and how the Fed will precisely pursue the "sustainable 2%" inflation target. Secondly, the Fed's rate cut starting in mid-September needs to be clearly communicated and consistent with market pricing.

Without these "anchors," we may repeat the market turmoil of the first three trading days of August.

In the event of economic weakness, these assurances are crucial for maintaining market stability and smooth operation, as well as avoiding the negative impact of market instability on the economy. They will also help ensure that market pricing is in orderly coordination with the recent estimates of many analysts regarding the risk of economic recession and the related expectations of Fed policy measures.

While concerns about inflation have subsided, the Fed's full task has become more uncertain.

I still estimate the probability of an economic soft landing at 50%, but the 35% probability of a recession on the left tail is too significant to ignore (the remaining 15% is distributed on the right tail, where the economy is larger but not prosperous due to a series of favorable supply shocks).

The recession risk scenario is vulnerable to adverse external developments, such as escalating conflicts between Hamas and Israel and/or Russia and Ukraine, as well as the Fed falling behind the curve. These risks will disrupt one element supporting the economy's consumption engine - stable labor income.

Combining this 35%-50%-15% distribution with my estimate of the long-term neutral rate and the possibility of an equilibrium inflation rate around 2.5% (rather than the Fed's 2% target), the market's implied path of a 200 basis point rate cut may be too aggressive If the most likely scenario for the macroeconomy shifts from a soft landing to a recession, my forecast for the Fed to cut rates by 150 basis points over the next 12 months would change. However, most of us hope to avoid this outcome, even if it means that the current market pricing of Fed actions is incorrect