The Fed is likely to cut rates, but inflation remains a question

Expectations of a rate cut at the Federal Open Market Committee's next meeting on Dec. 9-10 have gone from a split decision to the forward market giving a reduction a 95.9% probability as of Dec. 1.

In addition, the Overnight Indexed Swap Market is now pricing in three and half more rate cuts by the end of next year, with the effective federal funds rate falling from its current 3.88% to 3% next October.

Even with investors’ new conviction of a coming rate cut, though, the fog of uncertainty surrounding U.S. macroeconomic data has had a wide-ranging impact on financial markets and the economy.

Though the government shutdown ended on Nov. 12, it will be some time before policymakers, investors and the public get a good look at the direction of inflation, which through September was up by 3% from one year ago and by 3.6% on a three-month annualized pace.

In our estimation, the best inflation projection made during the 43-day shutdown was the New York Fed’s expectations for a 3.24% increase in the year ahead, in contrast with the University of Michigan’s year-ahead estimate of 4.7%. 

Our preferred market-based metric—the five-year, five-year forward breakeven rate—implies a 2.34% pace of inflation over a longer period.

But no matter how the data is sliced, inflation is likely to outpace the Fed’s 2% target, as the strong fiscal impulse that will hit the economy next year bolsters growth prospects.

Our models of the Federal Reserve’s reaction function—we run four separate models to estimate the optimal policy rate—all imply that it would be prudent for the central bank to keep further rate cuts on hold for now because of the uncertainty around U.S. macroeconomic data.

The central bank can resume reducing its policy rate once it gets a full accounting of the economic effects of the shutdown, which we think shaved roughly 1.5% from gross domestic product in the fourth quarter.

We are entering an interesting period in which economic populism is giving birth to ideas such as $2,000 tariff rebates—a purely inflationary measure, in our view—to mitigate the affordability crunch hurting middle- and lower-income households, which make up the lower spur of the K-shaped American economy.

At the end of the day, it is those consumers who live and work in the lower spur of the K that will bear the burden of adjustment to higher inflation through a lower standard of living, diminished opportunities and wages that will not adjust upward because of tariff-induced policy changes such as rebates.