Lower Interest Rates (Finally) on the Horizon

Seeking to lower inflation, the Federal Reserve began raising borrowing costs in March 2022 and held them at the highest level in more than two decades for the past year. Recent data on returning price increases to more normal levels has been much more encouraging than earlier this year. Simultaneously, the unemployment rate has risen gradually amid a softening in the broader labor market. Those two trends have strongly bolstered the case for the Fed to soon begin lowering interest rates.

Reducing inflation has been a bumpy road. Monthly data during the first quarter of this year were consistently above expectations, temporarily stalling the progress made in preceding quarters. The second quarter saw inflation resume its downward progress, culminating with inflation cooling in June to the slowest pace since 2021 on the back of a long-awaited slowdown in housing costs. Core consumer prices, which exclude volatile food and energy costs,
climbed 0.1% from May, the smallest advance in three years.

There remain risks that these plans may become unglued. Another uptick in inflation, for example, could push out rate cuts or significantly change their cadence. It is also possible that as we get closer to election day, the Fed may be reluctant to act for fear of appearing to influence the outcome. Or the Fed may simply be more cautious to act after its infamous prediction in 2021 that inflation would be transitory and therefore resolve itself.

When the Fed begins to cut rates, it remains uncertain how low they will go. In June, the headline CPI inflation rate fell to 3.0% versus last year and short-term interest rates were 5.3%, resulting in a real interest rate (or spread between the two) of 2.3%. The average of this real rate has been 1.0% since the late 1950s. As inflation wanes, there is an even greater rationale for continuously lower interest rates. The difficult part is determining when lower rates become too stimulative, enabling the next inflationary cycle.

With the labor market strong until recently, the Fed’s focus had been primarily on inflation. Now that the labor market has cooled materially and inflation nearing target levels, both segments of its dual mandate would benefit from lower interest rates. Lower borrowing costs are, therefore, likely not far off.

Holger Berndt, CFA
Director of Research
[email protected]