US Fed’s ‘balancing act’ to pay off, rate cuts coming: Principal AM

New market commentary for Q3 from Principal Asset Management (Principal AM) has confirmed expectations of a rate cut by the US Federal Reserve (US Fed) in September.

The report said the current economic cycle has presented the central bank with tougher-than-usual conditions for it to consider a rate cut, as it requires “perfect timing” to “cultivate a soft landing without reigniting inflation pressures”. It highlighted the similarities between the current cycle and the market conditions seen in the early 1970s.

“Indeed, the uncertainty around the last mile of progress for stubborn and sticky inflation undoubtedly complicates the Fed’s decision making. History clearly warns against cutting rates before inflation is on a sustainable path to target,” the report said.

During [the early 1970s], the Fed had also responded with steep interest rate hikes. After some time, it was anxious to ease monetary policy, cutting interest rates before inflation had fallen back to levels consistent with price stability. The result was a resurgence in price pressures.

“While it is not obvious that the economy requires policy easing, the very minimal of successful soft landings following a Fed hiking cycle demonstrates the dangers of waiting too long before cutting rates.

“Indeed, there are already signs that consumers are starting to show fatigue and that companies are considering labor costs, suggesting that the Fed risks throwing away prospects of achieving a soft landing if it waits too long.”

Principal AM also said fluctuating market rate outlooks have made it difficult for global central banks to remain synched, as others such as the European Central Bank (ECB) and Bank of England (BoE) typically assess the US Fed’s moves before making their own. However, the ECB made its first rate cuts ahead of the Fed in June this year.

“The ECB will be wary of its diverging policy path. A widening gap between U.S. and Euro area policy rates risks putting downward  pressure on the euro, in turn adding to inflationary pressures. Although the Euro area’s inflation has fallen, recent data have surprised to the upside, so the ECB cannot risk further significant euro depreciation.

“Some global policy coordination is required. The next ECB rate reductions are likely in September and December—the same months the Fed is likely to cut. However, if the Fed delays the start of its easing cycle until early 2025, the ECB’s next move may be equally delayed. The Bank of England (BoE) will likely begin rate cuts in August and then move at a pace similar to the Fed.”

Principal AM’s report confirmed the manager expects an initial rate cut in September followed by another in December, on the condition of “convincing and consistent evidence of slowing economic activity, a weaker labor market, and softening inflation”.