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Fed says March rate cut not base case after leaving rates unchanged this week

Markets were disappointed by Chair Powell saying March is not the Fed’s base case for its first rate cut at its recent Fed meeting.

The Fed wants to see more progress on inflation, even though headline PCE inflation – the metric for the Fed’s 2% target – is already down to 2.6% YoY (chart below, orange line) and core PCE is down to 2.9% YoY (blue line).

The longer the Fed waits to cut rates, the higher real rates will get

So markets are now pricing the first rate cut in May. If they’re right, the Fed will have gone 10 months between its last hike in July and its first cut (on average, Fed pauses have lasted 8 months).

Since the Fed’s last hike, though, inflation has been falling, pushing up real rates and making monetary policy more restrictive.

What’s the real rate?

The real fed funds rate is the nominal rate minus inflation. Another way to think of it is whether your interest income is enough to offset rising prices.

So while the Fed has paused the nominal rate at 5.5%, core PCE inflation has slowed from 4.2% YoY to 2.9% (chart below, blue line). That means this “pause” has seen real rates increase 130bps to 2.5% (red area).

Looking ahead, markets expect the fed funds rate to fall 1.5% by the end of the year (red circle), but inflation is expected to fall too (blue circle). So real rates will still be quite positive at the end of the year. In fact, the red bar at the end shows real rates will be close to 2%.

Current real rates at level consistent with past rate cuts

Research from Deutsche Bank shows that the Fed typically begins cutting rates when the real fed funds rate is between 2%-3% (chart below, arrows). At the start of the 2019-20 rate cut cycle, real rates were only about 1%. So current real rates are actually at – or above – a level consistent with past cuts.

If you look at the chart above, you’ll notice that the Fed started cutting at progressively lower rates since the late ‘70s (red line). In other words, a lower peak interest rate was needed to slow the economy.

A big reason why is demographics.

Since the ‘70s and ‘80s, the population has been aging, meaning we’ve seen slower labor force growth. When workers join the economy at a slower rate, economic growth naturally slows. In turn, the economy needs lower peak rates to cool it (chart below, red line) – which is exactly what we’ve seen.

With demographics taken into consideration, a real interest rate around 1% seems to be enough to slow the economy now. So even if the Fed cuts as much as markets expect, real rates will be relatively restrictive. And that increases the risk of recession caused by leaving rates too high for too long.

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