Last week, the Fed (US Federal Reserve) met to decide on the level of official interest rates. As expected, the US central bank left interest rates in the 5.25-5.50% range, but the market was anxious to hear any clues about the possible future path of rates.
Interest rates do indeed have an impact on the economy, and investors would like to see them reduced, as this generally helps the economy by making it less costly for consumers and businesses to finance their spending or investments.
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ToggleWhat are the signs of inflation?
Just before the Fed decision, new inflation data was released. For the first time, after a few months of disappointing data, the data came in lower than expected.
The monthly change in core inflation, which was the most closely watched data, came in at 0.2%, against the expected 0.3%. The year-on-year figure now stands at 3.4% for core inflation and 3.3% for headline inflation (core inflation excludes food and energy, as they are volatile components).
The trend, especially for goods inflation, is quite good. Only price increases for services remain high.
Why does inflation matter for monetary policy decisions?
The rapid rise in interest rates by central banks was aimed at slowing the economy and containing inflation. Central banks are waiting for inflation to show signs of cooling before lowering interest rates to less restrictive levels.
Why didn’t the Fed lower interest rates despite some signs of disinflation?
Basically, the central bank wants to see more evidence that inflation is actually slowing down. There have been cases in the past where cutting interest rates too early was accompanied by a further rise in inflation.
When will the Fed cut interest rates?
The US central bank will probably want to watch several more months of favourable inflation data. Investors now anticipate a 0.25% rate cut in September, with an estimated 75% probability.
Chairman Powell also said that interest rates could be lowered if the labour market weakens. At the moment, the labour market seems to show some cooling and labour demand and supply seem to be in better balance than after the pandemic, when companies had a lot of difficulty finding workers.
The graph below shows how, after the pandemic, there were up to two jobs available, on average, for every unemployed person. Now, that ratio has fallen to 1.25.
What are the expectations of the members of the Fed’s board of governors?
Every 3 months, the members of the Fed’s board of governors present their forecasts for interest rates. These forecasts are known as “dot plots” and represent a very interesting insight into what the Fed members think about the future, even though they do not in any way represent a formal commitment on the part of the central bank.
The latest dot plot shows that the median of the FED members’ forecasts anticipates one cut by 2024 and four cuts by 2025.
Why can the FED’s reaction function be considered asymmetric?
The latest “dot plot” actually forecasts only one cut for 2024. The previous one showed three declines. Despite the forecast of fewer cuts in 2024, the markets have performed very well. The planned cuts have been postponed until 2025.
Chairman Powell made it clear that the FED’s reaction function is now asymmetric. Interest rates are believed to be at a level that is above the long-run equilibrium level. This means that as of now, there is a very high probability that they are on a downward path. All that remains is to decide how quickly. On the contrary, an increase from these levels is extremely unlikely.
Therefore, for financial markets, what really matters is the expectation of a cut, it matters less how much and when.
What does it mean for our dollar savings portfolios?
Since the FED did not move official rates, there is no change in the portfolio’s Yield, currently at 5%. When a haircut occurs, there will be no effect on the value of the portfolio. The only effect will be that interest rates on the portfolio will accumulate at a slightly slower rate.
In any case, it seems that the members of the FED will want to lower interest rates very slowly, so our savings portfolio will continue to be a convincing way to park liquidity in dollars for a long time.