For the Fed, is Patience a Virtue?

Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services

• The U.S. equity market, represented by the S&P 500 index, rose 1% this week.
• Given inflation is slowing, what will the Fed’s next move be on monetary policy in 2024?

With inflation slowing and signs of labor market cooling, the consensus heading into 2024 was that the Federal Reserve would begin lowering its overnight target interest rate range from its currently held position of 5.25% to 5.5% as early as March.

Inflation came in a touch higher than expected in January. That data point provided fodder for Jerome Powell, the Fed Chairman, to declare that rate cuts were off the table for the Fed’s upcoming March meeting.

A more patient-than-expected Fed has emerged in 2024. Futures market odds of a rate cut in March have gone to zero, while the probability of a rate cut in May has fallen from 50% to 17%. As market pricing for rate cuts have been pushed out, medium- and long-term interest rates have nudged higher. The ten-year US Treasury note ended 2023 at 3.9%. It now stands at 4.3%.

While one month of higher-than-expected inflation does not make a trend, the Fed likely feels that it has some leeway on the timing of interest rate cuts. The economy has continued to chug along, and unemployment has remained low.

Which begs the question: how restrictive is the Fed’s current interest rate policy stance? Looking at market and economic data, it does not look very restrictive. A Bank of America Merrill Lynch measure of global financial stress is at its lowest point in four years. The easing in the Goldman Sachs Financial Conditions index over the last four months ranks as one of the most significant periods of relaxing financial conditions since 1982. The S&P 500 is at all-time highs, the economy accelerated into the end of 2023, and it appears to be on its way for another quarter of decent growth to start 2024.

Perhaps a slowdown has not occurred because higher interest rates have not yet coursed through the economy. Milton Friedman coined the term “long and variable lags” in the 1950’s to describe monetary policy’s impact, and Jerome Powell has frequently used that phrase in his press conferences.

The Fed itself may not be convinced of the received wisdom of “long and variable lags”, however. The Kansas City Fed published research in 2022 arguing that lags in monetary policy transmission have shortened because of the Fed’s use of forward guidance since 2009.[1] Overreliance upon “long and variable lags” without solid supporting evidence could lead to the Fed using more patience than justified before deciding to cut interest rates, raising the specter of a Fed “policy error”-driven recession.

So many variables factor into the current macroeconomic environment – strong household balance sheets, a wide US government fiscal deficit – that it is difficult to discern the impact from the Fed’s interest rate policy stance. Additional rate hikes are almost surely not in the cards, but should current dynamics continue, the Fed will feel more and more inclined to wait on rate cuts.