Digging in to Jackson Hole: Countdown to Rate Cuts

The moment we've all been waiting for is not quite here, but the countdown clock is ticking. Last week brought the Federal Reserve's annual symposium in Jackson Hole, Wyoming, a monetary-policy red carpet of sorts, where the movie isn't shown but previews and interviews add detail and anticipation. In this case, "Who are you wearing?" is replaced with "What are you seeing?" and "When are you cutting?" There were no policy decisions made at this meeting, but it did provide a prelude to the Fed's upcoming official meetings, where expectations for action are high.?

Markets spent the week largely treading water, awaiting the latest perspectives from monetary policymakers, including the much-anticipated speech from Fed Chair Powell on Friday. There were no surprise endings, but we do think the commentary provided some takeaways that will be important for markets ahead. Here are three of our key takes for investors:?

1.??? The wait is over, but the goalposts have moved

A September shift:?

Markets have been fixated on – and driven predominantly by – the timeline to rate cuts for the better part of the last year. The wait is almost over, as we think the commentary from Chair Powell is consistent with our (and the prevailing) view that interest-rate cuts will commence in September.? The Fed has held its policy rate steady for more than a year now, with the extended pause stemming from the fact that the central bank's dual mandate (stable inflation plus maximum employment) was not yet in a position that could warrant a change in policy settings. Our interpretation of the Fed's commentary last week is that officials now see sufficient movement on that mandate to begin adjusting rates. ?

Not just inflation anymore:

Importantly, however, we think the Fed's focus, in terms of the data guiding policy decisions, is shifting. With unemployment running below 4% from February 2021 to April 2024 (for perspective, the average over the last 40 years has been 5.8%), the employment side of the mandate has not required much attention. Conversely, with core inflation averaging 4.7% over the last 24 months (compared with a 40-year average of 2.9%), the Fed has focused policy moves squarely on bringing down inflation1.? With the trends in inflation and employment now both moderating, we expect the Fed's attention will now be more balanced, with an effort to support the labor market and economy playing a more prominent role in upcoming rate decisions.

• Progress on prices: The inflation fight has not yet been won, but with core CPI (consumer price index) at 3.2%, having declined for four straight months and now sitting at its lowest reading? since April 2021, we think sufficient progress has been made for the Fed to be able to ease monetary policy. Recent underlying price data suggest to us that the rate of inflation should continue to moderate and will not require the current restrictive interest rates to do so.
• Early signs of softness in the jobs market: July's underwhelming jobs report (in which monthly hiring slowed and the unemployment rate ticked up to its highest since October 2021) set off a rash of recession worries a few weeks ago, which sparked the early-August sell-off in stocks. We said then, and reiterate now, that the recession panic was overblown, with data in recent weeks supporting a more positive view. That said, we've been of the view since the beginning of this year that employment conditions would soften (but not collapse), downshifting the economy to a lower gear. We don't think a recession is on our doorstep, but some emerging cracks in what has been an otherwise incredibly solid labor market do warrant the Fed's attention. We expect upcoming rate decisions to reflect the Fed's effort to support a more material deterioration in employment conditions and stave off a more meaningfully economic slowdown.

Inflation has moderated, but there's more work to do:

This chart shows the comparison of inflation before and after the pandemic. Inflation rose significantly after the pandemic but has since come down closer to the Feds target. However, it still has a ways to go to get back to 2%.

2.??? This is not your grandfather's rate-cutting cycle

A different entry point:

Traditionally, the Fed starts cutting rates in response to an economic downturn, a financial shock/crisis, or both. The conditions are somewhat unique this time, as the Fed is not seeking to address a collapsing economy or arrest a seizing financial system. Put differently, the Fed often cuts rates to press on the gas pedal, stimulating a sputtering economy. We think the upcoming rate-cutting cycle is more about letting off of the brake, upon which the Fed has had its foot firmly pressed for the last two years. Inflation is coming down, but it is not yet back to the Fed's long-term target or sustainable (tolerable) levels. And unemployment has ticked up, but we don't see signs that the labor market or the economy is in need of immediate life support. So while neither of those, in isolation, scream for a rate-cutting cycle, real rates (interest rates minus inflation) are creeping higher, which we think makes the case for the Fed to gradually reduce rates to get monetary policy closer to a more neutral setting. ?

Won't be dramatic:

Given our comments above, we expect this rate-cutting cycle to start, and proceed, gradually. Barring a sharp and unexpected change in the path of inflation or unemployment, we think the Fed will make incremental, 25-basis-point (0.25%) cuts to its policy rate. The last rate cuts were in March of 2020, when the Fed executed a 50-basis-point and 100-basis-point cut, in emergency fashion, to address the fallout from the COVID-19 shutdown. The policy-easing cycle that began in 2007 commenced with an outsized cut (0.50%) and included numerous large rate cuts as we navigated the housing market collapse and global financial crisis. Similarly, the easing cycle following the tech bubble pop and 9/11 in 2001 included numerous 50-basis-point rate cuts. We don't see a need at this stage for a dramatic move by the Fed, and in the absence of any particularly weak upcoming jobs reports, we think a string of 25-basis-point rate cuts is the likely approach, as the Fed seeks to find a neutral stance for its policy rate. ?

Won't be preordained:

A point of emphasis that we took from Chair Powell's speech last week was that the Fed is going to be highly data dependent in making upcoming policy changes. Our interpretation is that instead of approaching this rate-cutting cycle as a path from here to some future destination, the Fed is going to assess incoming inflation and economic data and calibrate accordingly. We suspect this means the path for rate cuts may not be consistent, with cuts and pauses interspersed over meetings this year and next.?

We expect smaller and gradual rate cuts compared with prior crisis-driven downturns:

This chart shows the path of historical rate cuts from different levels starting in the late 1980's. Typically, once the Fed starts to cut rates, there are multiple cuts in the cycle.

3.??? Interest-rate cuts are typically favorable for the markets, and we don't think this time will be an exception

Making good on this year's market rally:

We think a shift to a phase of monetary-policy easing will be a tailwind for financial markets over the coming year. That said, this has been widely and eagerly anticipated, so a portion of that benefit has already been pulled forward into the stock and bond markets. Short- and longer-term yields have declined notably this year, reflecting expectations for a lower Fed policy rate. Meanwhile the stock market has returned nearly 40% since interest rates peaked last October1. However, we don't think the benefits of lower rates have been fully exhausted for the stock market. The ability for the Fed to lower rates in a manner that orchestrates a soft landing for the economy (avoiding recession) should, in our view, provide scope for corporate profits to rise at a healthy clip next year, which we believe would be a fuel source for this bull market to extend this year and into 2025.

History and the current starting point warrant a positive view:

Rate cuts are not a cure-all, but we do think less restrictive policy is good news. While this doesn't reintroduce 3% mortgages or deliver a heavy dose of monetary stimulus, this is a step toward less burdensome borrowing costs for consumers and businesses. Lower rates can also be supportive of stock-market valuations and bond-market returns. We think this is largely demonstrated by the broader performance of equities in the one and two years following the commencement of rate cuts, shown in the table below. Recognizing that the dot-com bust and 9/11, as well as the global financial crisis, produced weakness that extended well beyond the start of the rate-cutting cycles, we think that history is on investors' side when it comes to post-rate-cut market returns1. Looking at periods like 1987, 1995 and 1998, when rate cuts were not accompanied by an ensuing recession, returns in the following one to two years were particularly strong1. As we noted, a recession can't be completely ruled out, but we think the economic expansion will continue. We think the Fed initiating rate cuts from the current position of employment, consumer spending, and overall GDP growth supports such an outcome and a broadly positive view for financial markets ahead. Read the full Weekly Wrap here: https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/stock-market-weekly-update.

Broader market performance following initial rate cuts has typically been positive if the economy holds up:

Source: 1. Bloomberg

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