What is the basis for the Federal Reserve's interest rate decisions?

Faced with a series of microeconomic data in the recent period on inflation, labor market and consumption, as well as pressures on capital markets and commercial real estate… all making the market hope that the Fed will cut interest rates soon. 

Therefore, the statements of FOMC members last week were eagerly awaited by the market – mainly to seek signals on the possibility of the Fed cutting interest rates next year. These developments can be summed up in one sentence:

“Last week started with Waller, ended with Powell… and the market interprets the message from the Fed the way the market wants!”

This is also the opening content in this weekend's macroeconomic article by Viet Hustler, including 3 key important pieces of information:

1. Message from the Fed last week and the market's attitude…

2. When is the right time for the Fed to cut interest rates?

3. The key variables in a Fed macroeconomic equilibrium model to make interest rate decisions.

1- Message from the Fed and the market's attitude

Last week started with Waller, ended with Powell…: 

• Christopher Waller (once one of the most “hawkish” Fed officials) started the new week with a rather dovish statement: 

  • … policy is well positioned 

  • … high interest rate policy to curb inflation must be traded off with a slowing economy… (something appears to be giving, and it’s the pace of the economy)

• Despite the tough statements from the other members mid-week, Powell also ended last week with a statement that “sounds hawkish but is interpreted by the market as dovish”:

  • … too early ("premature") to cut interest rates…

  • … the Fed plans to “keep policy restrictive” to ensure inflation is firmly at 2%....

This move by Powell partly affirms that the Fed will not raise interest rates anymore, but will also not cut interest rates easily – to curb the market's “overly positive and excited” attitude last week…

• …when investors continuously invest in risky assets expecting the Fed to cut interest rates soon. 

  

… and the market interprets the message from the Fed the way the market wants:

Even though Powell warned that it is too early to talk about rate cuts, and even other members still leave open the possibility of raising interest rates,... the market still only believes what they want…

… especially when they interpret the “conciliatory” statements of Fed members in a dovish direction:

• In just 1 week, market expectations have changed markedly:

  • Last Friday (11/24), the market had only price-in 3 Fed rate cuts in 2024 (orange line on the chart)

    – with the first rate cut expected at the FOMC meeting in June 2024.

  • Then by this Friday (12/01), the market “confidently” price-in as many as 5 rate cuts in 2024 – starting from March 2024.

  • Expectations for interest rates by the end of 2024 are 4.1% - by the end of 2025: 3.57%.

  

2- When is the right time for the Fed to cut interest rates…

Based on inflation data (Core CPI)

The correlation between the Fed's policy rate and Core CPI growth is shown in the scatter plot below (red line is fitted line):

• Black dots are the periods before the Fed started cutting interest rates.

• Based on this data, the Fed may cut rates when Core CPI falls below the Fed rate (upper bound) by about 2 - 2.5% (= Fed rate - Core CPI) .

  • That is, if the upper bound of the interest rate is at 5.5%, Core CPI must fall to around 2.5% - 3% for the Fed to consider cutting rates…

    — while current Core CPI (as of October) is still at 4% Y/Y.

  

So when will Core CPI fall to 2.5% - 3%: it depends greatly on housing CPI – the component accounting for 42% of last month's Core CPI growth. 

• The latest rental contracts in the market have shown a slowdown in rental price growth. 

• However, the rent component in CPI is based on both old rental price statistics (as the data collected is average data). 

• It may be by the end of April 2024 that the CPI rent index reflects the actual growth rate (which has slowed).

  

Therefore, according to 3Fourteen, if based on predictions about the housing CPI index, it seems that starting from May, the Fed will begin cutting interest rates – just as the market's previous prediction from last week.

Based on labor data

In 2023:

• … the economy has created additional ~+1.668 million new jobs (non-farm payroll number)…

• … but the labor force participation only increased by +1.447 million people.

• The reason is that there are up to > 700,000 people working more than 1 job…

  

  (Disclaimer: The above CPI and employment data is mainly excerpted from the 3Fourteen Research source, along with a few subjective comments from Viet Hustler).

• Therefore, the unemployment rate also increased by +0.5% (from 3.4% in January 2023 to 3.9% at present).

  

• And in reality, the non-farm payrolls number only increased in 52/389 urban areas in the US…

  

• … while the unemployment rate has risen in 223/389 urban areas in the US…

• … showing that the pace of job growth is not uniform with the pace of layoffs by businesses in these urban areas.

  

Sahm Rule has warned that the unemployment rate could escalate quickly if there is momentum (the latest 3-month average increases +0.5% compared to the previous low)....

• … because recession can 'self-escalate', in which rapid unemployment rate increase (stemming from businesses successively laying off en masse) is the most important criterion – leading to consumers' sudden spending cut decisions.

• Read more about Sahm Rule: Risk of recession returning through recent economic fluctuations (middle part of the article)

  

• No official summary of the numbers yet, but recent announcements of employee layoffs or delayed salary payments by global businesses are signs that the Sahm Rule is gradually materializing.

  

• With businesses' difficulties in the upcoming credit crunch environment, the Fed may take specific action when the Sahm Recession Indicator reaches +0.5%.

  • However, note that the 1-month growth (Sep-Oct 2023) does not reflect the actual upward trend of this indicator.

Based on economic growth data (GDP growth)

First, it must be emphasized that even if GDP for 1-2 quarters declines slightly, it does not mean the Fed will cut interest rates (as in early 2022)…

— The Fed will act based more on signs of inflation and the labor market (above).

However, GDP is a variable that the Fed must consider to reach conclusions on interest rates.

FYI: Both Atlanta Fed and S.Louis Fed have cut their immediate (Nowcast) predictions for Q4/2023 GDP:

• Atlanta Fed GDP Nowcast: +1.2% q/q (last week: +1.8% q/q)

  • In which Atlanta Fed has cut the household consumption growth prediction to half compared to last week.

    

• S.Louis Fed Nowcast: +1.89% q/q (previously: +2.04% q/q)

  

• However, New York Fed still raised its GDP Nowcast forecast to +2.26% q/q (previously: +2.17% q/q).

  

3- Key variables in the Fed's interest rate balancing model

One of the Fed's macroeconomic equilibrium research models is based on the combination of Taylor Rule (based on DSGE model equilibrium) and Okun's Law (based on empirical research):

• Source: Fed’s Principles for the Conduct of Monetary Policy

In which: 

• R_t = Fed's current nominal federal funds rate

• r^LR = Fed's long-term federal funds rate target (2% – see link above)

• Pi_t = Current PCE inflation - Fed's preferred measure in models (+3.0 y/y)

• Pi* = Long-term inflation target (+2% y/y)

• u^LR = Long-term unemployment rate (Fed estimate 4%)

• u_t = Current unemployment rate (3.9)

=> The above equilibrium will give the nominal federal funds rate set by the Fed:

… equivalent to the upper bound of the Fed funds rate (5.5%).

Not to mention in the previous period, when PCE rose too high causing R_t to be higher than the actual Fed rate increase.

=> This is exactly the reason why:

• Previous period: Fed officials always emphasized the need to continue raising rates (of course they can only raise rates gradually to avoid impacting financial conditions). 

• Currently: Fed officials emphasize maintaining the current rate level until inflation falls (Pi_t falls) or unemployment rises (u_t rises)…

  – at that point the Fed's federal funds rate (R_t) can be lowered below the current level.

=> This is also the message Viet Hustler wants to send to readers:

• If inflation (PCE) falls -1%, Fed can cut rates to -1.5%.

• If unemployment rate rises +1%, Fed will also cut federal funds rate by -1% accordingly.

CONCLUSION

Although statements from officials last week conveyed mixed messages from the Fed, the market is overly optimistic in continuing to price-in 5 Fed rate cuts in 2024.

Meanwhile, based on historical experience, core CPI needs to fall another 1% - 1.5% for Fed to start cutting rates. Lagged housing CPI data suggests inflation may fall as Fed desires by end-April, so Fed can only start cutting from end-May. However, according to Viet Hustler, these views are more experiential than logical.

Viet Hustler believes labor market and inflation are the 2 key points Fed is watching now. Based on Fed's own research, labor market will signal tension from early corporate layoffs, especially when Sahm recession indicator rises to +0.5%. And precisely from the macroeconomic equilibrium model Fed uses based on Taylor Rule and Fed's Okun's Law:

• If inflation (PCE) falls -1% (other variables unchanged - ceteris paribus) then Fed can cut rates to -1.5%.

• If unemployment rate rises +1% (ceteris paribus) then Fed will also cut federal funds rate by -1% accordingly.

Finally, Viet Hustler readers may be interested in the heatmap below, summarizing current economic situation across US states — compiled by Medley Advisors based on US Beige Book.