Could the Fed cut rates sooner than markets expect?

On the latest edition of Market Week in Review, Investment Strategy Analyst BeiChen Lin and Equity Manager Research Analyst Michelle Batjargal discussed whether the U.S. Federal Reserve (Fed) will need to hold policy rates at high levels for a longer period of time, or if the central bank could potentially cut rates in 2024. They also chatted about the importance of staying disciplined amid the recent uptick in market volatility.

Why a higher-for-longer narrative isn’t the only possible outcome

Batjargal and Lin kicked off the conversation by discussing how long the Fed may need to keep interest rates at elevated levels. Noting that the federal funds rate currently sits at its highest level since 2001, Lin said the central bank’s September projections indicate that FOMC (Federal Open Market Committee) members expect rates to remain elevated for quite some time. "The consensus among Fed officials at their latest meeting was that rates would remain above the so-called neutral rate – the interest rate that neither stimulates nor slows the economy – through the end of 2025," he explained.

While markets have latched on to this higher-for-longer narrative, Lin said that rates may not necessarily remain elevated for that long. Why? One reason would be if a recession strikes the U.S. within the next 12-18 months, he said. Lin explained that in a recession, the Fed would likely have to slash interest rates rather aggressively – taking interest rates below the neutral rate – in order to return monetary policy to an accommodate stance to boost economic growth. "At Russell Investments, our baseline scenario is still that a mild-to-moderate U.S. recession is likely before the end of 2024," he noted.

Lin emphasised, however, that a U.S. recession is not necessarily inevitable, as the Fed could still engineer a soft-called soft landing. "A soft-landing scenario isn’t our base case, but if the Fed does pull one off, central-bank officials would still probably lower interest rates," he remarked. In this instance, the Fed probably wouldn’t cut rates as aggressively as it would in a recessionary scenario, but it could still bring monetary policy into more of a neutral stance if inflationary pressures were to dissipate, Lin remarked.

The bottom line? In either of the two scenarios – a recession or a soft landing – the Fed would likely still cut rates, he said, noting that both scenarios are a little at odds with the market’s expectation that rates will remain elevated for a lengthy period of time. Lin added that there is some uncertainty about what exactly the neutral rate is, explaining that the Fed estimates it’s close to or within a range of 2.5%-3% in nominal terms.

"Ultimately, from my perspective, while the market seems to have latched on to this higher-for-longer narrative, it’s worth reminding investors that other outcomes are possible as well. In particular, I think it could very well be the case that markets will have to contend with a recession in 2024, in which case rates could fall aggressively," Lin concluded.

The importance of staying disciplined during volatile markets

Batjargal and Lin finished the segment by discussing what investors might want to consider in light of the recent uptick in market volatility. "Volatility – and the potential risk of a recession – are some of the unpleasant facts of life that investors simply have to deal with. It’s understandable that a lot of investors get scared when they hear talk of a recession. But it’s important to realise that recessions are a normal part of the business cycle," Lin stated, stressing the importance of staying calm and disciplined during times of market unrest.

Lin said that amid the rocky start to October, he’s seeing some signs of investor pessimism creeping back into the market, following a months-long stretch where investors were generally pretty optimistic. "At Russell Investments, this mounting pessimism is a good reminder to us that we need to remain disciplined and stay cautious without becoming overly defensive," he concluded.

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