The Fed signals one rate cut in 2024, but the end game remains the same

Key takeaways:

• The June FOMC meeting and U.S. inflation data were front and center last week, with both offering some positive news for the bulls.
• Inflation data came in lower than expected, with headline CPI inflation for May coming in at 3.3% year-over-year, below forecasts and last month's 3.4%. After a string of hotter U.S. inflation readings for the first three months of the year, last week's reading was welcome news for markets.
• As expected, the Federal Reserve also kept rates on hold at its June meeting at 5.25% - 5.5%. The Fed's updated set of estimates pointed to one rate cut in 2024, down from the three rate cuts forecast at its March meeting. However, the Fed indicated that the fed funds rate is still expected to reach 3.1% by 2026, the same as its March forecasts. Overall, while the pace of rate cuts may have shifted, the end game for the Fed remains the same: Interest rates are likely to moderate over the next two to three years.

A welcome surprise lower in inflation

After several hotter-than-expected inflation readings for the first three months of the year, the May CPI data was a welcome shift and some affirmation that inflation does not seem to be re-accelerating. The U.S. consumer price index (CPI) and producer price index (PPI) inflation readings for May both came in lower than expected. CPI inflation was supported by flat food prices and lower energy prices last month, as well as a fall in new car prices and airline fares.1?The overall headline CPI inflation came in at 3.3% year-over-year, below expectations and last month's 3.4%.1?Core inflation, excluding food and energy, was 3.4% in May, below forecasts of 3.5% and last month's 3.6%. We would, however, expect the Fed to want to see at least two to three better inflation readings before signaling any potential rate cut.

What would drive inflation lower from here?

As Jerome Powell noted in last week's press conference, there are some potential drivers that could move inflation closer to the Fed's 2.0% target from here: 1) shelter and rent components of the CPI basket moderating, especially given real-time data has already slowed; and 2) services inflation potentially moderating as the labor market cools and wage growth slows. In our view, while we may not get a straight-line lower in inflation, we believe the path of disinflation should continue in the months ahead, giving the Fed more comfort to signal rate cuts.

The Fed's estimates still point to an "end game" in rates of 3.1% by 2026

Markets were eagerly anticipating the Fed's updated "dot plot" at this June meeting, which essentially is an outline of the FOMC voting members' views of where the fed funds rate should be over the next three years. The March dot plot had pointed to three rate cuts in 2024, while last week's updated version only had one rate cut penciled in for this year. On the surface, removing two rate cuts from this year may have seemed hawkish; however, if we look toward 2025 and 2026, the dot plot still points to a terminal rate of 3.1%. In our view, this implies that while the Fed may be uncertain on the pace of rate cuts, the end goal remains the same: It expects to gradually lower interest rates toward a more neutral level over the next 12 - 36 months.?

From an economic perspective, this implies better borrowing costs for both households and corporations in the months and years ahead, and savings rates that may be gradually moving lower. For markets, lower interest rates are historically supportive of better valuations and tend to coincide with an upturn in cyclical sectors. As we get closer to Fed rate cuts, we may see a more sustainable broadening in market leadership beyond mega-cap technology as well.

The Fed outlines a "soft landing" in the economy

Finally, the Fed's updated set of economic projections signaled a clear view: The U.S. economy is likely headed toward a soft landing. In fact, the Fed projects that U.S. GDP growth will remain at or above 2.0% through 2026, while the unemployment rate will remain steady between 4.0% and 4.2% over the next three years. Despite months of restrictive interest rates, the Fed does not see any meaningful deterioration in the economy or outsized softness in the labor market. In addition, the Fed still believes inflation will fall to 2.0% by 2026, even as economic growth remains steady.

In our view, this soft landing continues to remain a base-case scenario for the U.S. economy. Productivity in the U.S. has more recently trended higher (most likely driven by labor shortages) and may continue to do so, as artificial intelligence (AI) efficiencies are realized across sectors. While consumption and the labor market may cool, this slowdown may indicate normalization from elevated economic growth rather than a meaningful deterioration. If inflation does moderate and the Fed embarks on a rate-cutting cycle, this could also spark better economic momentum in the years ahead.

The risks to this soft-landing view are, of course, that either inflation does not moderate as expected – and perhaps even reaccelerates – or that the economy or labor market deteriorates more than anticipated. In our view, neither of these scenarios are currently supported by the data or leading indicators of the economy. We continue to see healthy consumption patterns, relative strength in the labor market, and most recently, inflation data that have eased more than expectations.?

Market opportunities ahead

Overall, we believe the Federal Reserve has outlined a conservative approach to its 2024 economic and policy outlook. If inflation continues to moderate, or if the labor market and wage gains cool more than outlined, the door is likely open for a second rate cut in 2024 and ongoing cuts in 2025 and 2026. Markets should also take comfort that the Fed forecast core PCE inflation to reach 2.8% in 2024; this is where core PCE inflation is currently, and it looks poised to move lower given the better CPI and PPI inflation data we saw last week.

More broadly, with the terminal fed funds rate likely in the 3.0% - 3.5% range (the Fed has 3.1% penciled in for 2026), interest rates and Treasury yields in the U.S. economy may remain elevated versus recent history. Keep in mind that even though the 10-year Treasury yield in the 10 years after 2008 was in the 1.5% - 2.5% range, it may fall to a more modest 3% - 4% range in the years ahead. In this backdrop, bonds continue to offer an interesting yield for investors, and stocks remain well positioned. In equities, we favor U.S. large-cap and mid-cap stocks, and within U.S. investment-grade bonds, we recommend slightly extending duration, all of which could perform well as the economy normalizes and rates in the U.S. move gradually lower.

Read the full Market Wrap here: https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/stock-market-weekly-update

Source: 1. FactSet

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