Cheng Shi's comments on the 2024 Federal Reserve FOMC interest rate meeting: The pace of interest rate cuts is expected to slow down

(The author of this article is Cheng Shi, Chief Economist of ICBC International)

　　In the early morning of February 1, Beijing time, the Federal Reserve announced that it would keep the benchmark interest rate unchanged. Powell said that despite the current strong U.S. economy, inflation is on the downward trend as expected. However, the US has not yet achieved a "soft landing", the job market is slowing down marginally (the job vacancy rate has fallen significantly), and more data is still needed to support whether the downward trend in inflation will continue in the future. Powell's stance on when the Fed will start cutting interest rates remains vague but pointed out that the Fed will not rush for a while, and from Powell's repeated emphasis on inflation targeting and the recent attitude of some Fed members to support gradual rate cuts, we believe that the Fed may not cut interest rates in March as widely expected. Judging from the fundamentals, judging from the policy turning point, although the dual income and wealth effects of fiscal expansion for the household sector for two consecutive years are still supporting the U.S. economy, considering political and inflationary factors, the fiscal expansion is unlikely to continue as in 2023. In our view, when the fiscal effect of the expansion substantially fades, inflation will accelerate further, which will be the prelude to the Fed's interest rate cuts. The Fed is expected to cut interest rates as early as May this year (April 30-May 1). Finally, we raised the probability of a "soft landing" for the US economy (i.e., no recession), corresponding to a rate cut of 75-125 basis points (3-5 cuts for the year).

　　The core of the US economic recession lies in the effective support of the "income effect" and "wealth effect" by timely macroeconomic policies. In the fourth quarter of 2023, real GDP in the United States significantly exceeded market expectations to achieve an annualized growth of 3.3% quarter-on-quarter. At the same time, in January 2024, the IMF sharply raised its forecast for the annual GDP growth rate in the United States (from 1.5% to 2.1%). At this interest rate meeting, Fed Chairman Jerome Powell expressed some optimism about the current state of the economy, which may suggest that the US interest rate cut may not be as expected by the market to start in March. We believe that the core of why the U.S. economy has not been in recession for a long time lies in the fact that the U.S. has maintained the stability of the "wealth effect" and "income effect" of the U.S. household sector through the effective combination of fiscal and monetary policies. Although the U.S. has been affected by high inflation in 2023, the Federal Reserve has tightened monetary policy sharply in an effort to stabilize inflation. However, the large-scale transfer of fiscal payments from the U.S. fiscal sector to the residential sector underpins the "income effect" of U.S. residents. At the same time, the withdrawal of part of the labor force caused by the epidemic has forced employers to raise the salary level of employees. Excess savings from transfers and rising disposable income from corporate wage increases directly support the upward movement of household final consumption expenditure. Strong consumption and the influx of additional savings into the stock market through the retail market have led to the continued strength of U.S. equities and continued to amplify the "wealth effect" of the household sector. Overall, the U.S. economy remains strong through the first quarter of 2024, reflecting that the dual income and wealth effects of fiscal revenue on the U.S. household sector have not declined significantly.

　　A substantial fiscal exit would be a prelude to a substantial rate cut. The cumulative effect of monetary policy rate hikes is being hedged by the dual effect of income and wealth brought about by active fiscal policy. This gives the Fed more room to control inflation and slow down rate cuts. However, we continue to believe that although the pace of Fed rate cuts will slow further, the current revenue and wealth effect of active fiscal policy will not be sustainable in the long term. As the 2024 U.S. election approaches, the confrontation between Republicans and Democrats will gradually enter a white-hot phase, and the Republican Party is restricting further fiscal expansion by the Democrats through Congress. On the other hand, in 2023, the cumulative investment expenditure of US private companies, supported by US fiscal subsidies (through the CHIPS Act), exceeded $200 billion (of which 80 billion was invested in chip-related manufacturing and 120 billion in infrastructure related to computer plants) supported by US fiscal subsidies (passed through the CHIPS Act). Considering that most of the more than 120 billion yuan of infrastructure expenditure related to computer factories has been implemented, the continued financial stimulus for the infrastructure of computer factories is unsustainable. As a result, fiscal support for non-residential investment will be significantly narrowed in mid-2024 (support for computer plant infrastructure is expected to fall back to $20-40 billion in 2024), and non-residential investment in the United States will be hit. In his speech, Powell also mentioned the question of whether the economic data is sustainable, and he believes that the US economy is still difficult to say that it has achieved a "soft landing" (no recession), and the economic data in the next 3-6 months may be the key to announcing whether the US is heading for the final victory. We expect the positive impact of the current fiscal support on the US economy to fade in the second quarter of 2024. Therefore, if long-term inflation expectations are well anchored and the sustainability of the downside is supported by broader economic data, then the Fed will start cutting interest rates as early as April-May.

Forecasts of the path and magnitude of U.S. interest rate cuts under different scenarios. Previously, we divided the Fed's rate cut path into three scenarios. Historically, even if the U.S. economy does not experience a recession, the Fed will cut interest rates in the range of 75-125bps in a single year during the "soft landing" of the economy. Considering that the wealth effect of the US fiscal expansion is likely to continue into Q2 and consumer confidence and retail sales are more sustainable, we have raised the probability of a "soft landing" (recession-free) for the US economy to 50%. The probability of a mild recession in the US economy was lowered to 35% (a mild recession corresponds to a rate cut of 150-200bps). In the pessimistic scenario, if the US falls into a "hard recession" (similar to the four recessions after 1950 in 1951, 1975, 1980 and 2008), then the US will cut interest rates in the range of 250-350bps per year. At present, even if the U.S. fiscal policy is withdrawn, if the monetary policy is introduced, it will hedge some of the risks of fiscal withdrawal, especially the impact on the "wealth effect" of the household sector, so the probability of a recession in the U.S. economy is decreasing. According to the London Stock Exchange's (LSEG) Interest Rate Probability app, Fed Funds futures expect five rate cuts of 25 basis points in 2024. This suggests that the market still seems to be betting on the possibility of at least five rate cuts by the Fed this year. In our view, more rate cuts will only occur if external geopolitical uncertainty intensifies and the inconsistency of fiscal and monetary directions materially affects the effect of interest rate cuts, which we view as an unexpected scenario.

(The author of this article is Cheng Shi, Chief Economist of ICBC International)

The views expressed in this article are solely those of the author.