Schroder Investment: Is the Federal Reserve playing with fire?

According to the Wise Finance APP, Schroders Investment released a research report stating that due to the uncertainty of the "neutral" interest rate level, the Federal Reserve's aggressive rate-cutting cycle may reignite inflation risks. Schroders believes that the risk of underestimating the neutral interest rate is greater than overestimating it. This requires a more cautious easing pace than currently expected by the dot plot. Therefore, the current expectation is still that the committee will cut rates by a quarter point in March and June 2025 respectively, and then pause the rate-cutting pace to assess the effectiveness of the cumulative 1.5 percentage points of easing policy already implemented by then. If inflation remains under control thereafter, this should pave the way for further moderate monetary policy easing in 2026.

When the Federal Reserve initiates a rate-cutting cycle with a half-point reduction, it usually attracts attention from the investment market. The United States previously took similar actions in January 2001 and September 2007 (three to four months before the US economy entered a recession), as well as at the beginning of the global pandemic outbreak in March 2020. Based on the appearance of this move, the bank assumed that the Federal Reserve would draw on the practices of mid-cycle adjustments in 1995, 1998, and 2019. In those three adjustments, a slowdown in economic growth (rather than a recession) prompted the Federal Reserve to start rate cuts with a standard quarter-point reduction.

Schroders stated that only the Federal Open Market Committee (FOMC) chose the more aggressive half-point reduction, aligning with the expectations of 91 out of 100 other economists surveyed by the bank and institutions. Federal Reserve Chairman Powell attempted to position this as a "recalibration" during the press conference, mentioning this point at least nine times, while emphasizing the long and variable lags in the effectiveness of monetary policy. This implies that for the current stage of the economic cycle, interest rates are overly tight, and the Federal Reserve also hopes to return to a neutral interest rate as soon as possible.

While Powell's logical reasoning can be understood, it is deemed unnecessary to take such an aggressive monetary easing pace. Neutral is an imprecise concept, not a measurable number, but a theoretical interest rate level that is neither too tight nor too loose to bring economic growth and inflation back to a stable and predictable path. However, if there is an aggressive rate-cutting cycle and the US economy proves to be more resilient than policymakers expected, US monetary policy may end up being overly loose, potentially below the neutral level, reigniting inflation.

Federal Reserve Governor Bowman seems to share similar concerns, as she supported a quarter-point rate cut at the September monetary policy meeting. She believes that the US labor market is still close to full employment, even though there have been recent signs of weakness due to data calculation and immigration issues. Despite a significant easing in inflation, she believes it is premature to declare victory, so it is best to proceed at an appropriate pace to avoid unnecessarily stimulating demand.

However, Bowman appears to be in the minority. Federal Open Market Committee members' "dot plot" forecasts for the end of 2024 predict a further half-point rate cut on top of the current 5.00-4.75% federal funds rate range by the end of the year. Although this may be somewhat excessive, it is best not to go against the Federal Reserve. Therefore, it is expected that the Federal Reserve will cut rates by a quarter point in November and December, compared to the previous expectation of a rate cut only in December. In addition to the significant rate cut in September, this additional rate cut of half a point beyond previous expectations has led the bank to raise its growth forecast for 2025 from 2.1% to above consensus Schroders' risk on interest rate forecasts is downward. It is currently unclear whether the investment market has led to the Fed cutting interest rates by half a basis point in September, but even so, the committee should not turn this approach into a habit. The latest forecasts include an "aggressive rate cut" scenario: in this case, concerns about the economic growth outlook convince the committee to implement the market-expected aggressive rate cut. The bank believes that this will ultimately lead to a re-acceleration of the pace of inflation, prompting the committee to have to start raising rates again