Deutsche Bank believes that it is too early to plan for a pause; the Federal Reserve can easily cut interest rates at next week's meeting and can also lower rates by 25 basis points in December. If core PCE is above target and employment market indicators remain robust, the Federal Reserve may consider skipping a rate cut at subsequent meetings
A series of strong economic data recently led to a sudden shift in the narrative regarding the Federal Reserve's interest rate cuts. After a 50 basis point cut in September, the market began discussing when the Federal Reserve might skip a meeting, i.e., pause rate cuts.
Deutsche Bank noted in a report on Tuesday that according to policy rule models, it is still too early to plan for a pause; the Federal Reserve could easily cut rates at next week's meeting and also cut by 25 basis points in December.
However, as we enter 2025, the reasons for skipping or pausing rate cuts will strengthen, as the Federal Reserve will be closer to neutral interest rate levels, and policy decisions after next week will partially depend on data.
The Federal Reserve may need two factors to skip—evidence of more persistent inflation and a mitigation of labor market downside risks. If core PCE is above target and employment market indicators are robust, the Federal Reserve may consider skipping rate cuts at subsequent meetings. It is worth noting that seasonal residuals early next year may push inflation higher, and the outcome of the U.S. elections may increase the hawkish risks for the Federal Reserve.
There is room for further rate cuts, at least 100 basis points away from neutral rates
Deutsche Bank considered five rules typically cited by the Federal Reserve, including in their monetary policy reports: the Taylor rule and balanced approach rules, including standard versions and enhanced versions for the new policy framework, as well as first-difference rules.
Using the policy rules commonly employed by the Federal Reserve, including the Taylor rule and other balanced approaches, Deutsche Bank found that there is room for further rate cuts:
Assuming core personal consumption expenditures (PCE) align with the Federal Reserve's estimates, based on the median forecasts for NAIRU and r-star from the Federal Reserve's September SEP of 4.2% and 0.9%, respectively.
Policy rules suggest that the federal funds rate should be between 3.6% and 4%;
However, some more hawkish assumptions, such as the Congressional Budget Office's (CBO) estimate of the natural unemployment rate (NAIRU) at 4.5% and Laubach-Williams' estimate of r-star at 1.2%, indicate that the policy rate should be between 4% and 4.5%.
At the same time, the Deutsche Bank report pointed out:
The neutral rate may be higher than generally expected, with a suggested nominal neutral rate of about 3.5%. However, the estimates for r-star vary widely, and the nominal neutral rate could be between 2.75% and 4.5%. Most estimates show that the current federal funds rate is at least 100 basis points or more above the neutral level.
How much more can the Federal Reserve comfortably cut rates?
Regarding how much more the Federal Reserve can comfortably cut rates, the Deutsche Bank report stated:
If the neutral rate is close to the Federal Reserve's medium-term estimate, they have considerable room to cut rates and should be able to cut again in December and the first quarter of next year without concern.
If r-star is close to our estimated 1.5%, the Federal Reserve could cut rates again in December without risking bringing rates down to the levels specified by policy rules or below.
If inflation continues to ease thereafter, further cuts in the first quarter of next year would be reasonable. However, if r-star is 2% (or higher), then the room for comfortable rate cuts will be limited after November Overall, the Federal Reserve should be able to comfortably lower interest rates next week without bringing the policy rate below the levels prescribed by the rules. A 25 basis point cut in December should also be relatively comfortable, although this would push the policy rate to the high end of the range when the estimated r-star is assumed to be higher.
What data would lead to a skip?
Further, when would the Federal Reserve skip a rate cut? Deutsche Bank's report points out:
The Federal Reserve may need two conditions to decide whether to skip a meeting: more persistent inflation and a reduction in labor market downside risks.
If core PCE is above target and employment market indicators are robust, the Federal Reserve may consider skipping a rate cut at the upcoming meeting.
Deutsche Bank stated:
The above conditions may be in place by December, although data affected by hurricanes and the December CPI report may introduce complexities. Our baseline forecast is that the Federal Reserve will cut rates by 25 basis points at that time, and they can still comfortably lower rates to below 4.5%. However, data after December may more clearly point to a skip or pause, especially if residual seasonality appears again in early next year's inflation data.
Election results are also a significant influencing factor; a comprehensive Republican victory without tariffs would be a hawkish outcome for the Federal Reserve. Other possible hawkish scenarios include a strong underlying economy with more persistent inflation at higher levels during President Trump's term with tariffs implemented; or if Harris is elected president, and the Republican-controlled Senate extends the Tax Cuts and Jobs Act and provides moderate fiscal support to the economy, this could also constitute a hawkish scenario