My Out-On-A-Limb Prediction of No Rate Cut

On Yahoo Finance Live this morning, in an interview with Madison Mills and Seana Smith , I bucked the markets by sticking with my prediction that the Fed is likely NOT to cut the policy interest rate at this month's FOMC meeting. Here's why.

1. The Fed tries very hard to maintain its independence from political pressure, so it doesn't want to be accused of taking action for the purpose of affecting an election. One of the Presidential campaigns has already floated the accusation that the Fed will cut rates for the purpose of helping the other Presidential campaign. The Fed would rather avoid that kind of criticism, so it won't cut rates unless it really needs to do so to protect the economy. And...
2. It doesn't need to cut rates to protect the economy. Overall macroeconomic conditions have moved from too-hot (meaning inflationary pressure) to just-about-right, with no significant signs of softness. The last Employment Situation report showed the labor market still resilient, with signs of weakness (lower-than-expected growth in payroll employment) neatly balanced by signs of strength (higher-than-expected growth in average hourly earnings). This morning's Retail Sales report and this morning's Capacity Utilization report were both just about where they should be. When the economy actually starts to move into recession (and it will, someday), that is likely to be heralded by weakness in labor markets AND income/wage growth AND consumption that is sustained over multi-month periods and/or severe enough not to count as "ticks." And...
3. It doesn't want to run the risk of allowing inflation to rear up again, as it did in the early 1980s.

My hosts pointed out that market trading implies absolute certainty of a rate cut at this month's FOMC meeting--the implied question being simply whether it'll be 25 bps or 50 bps. That was exactly the expectation at the beginning of this year; I made essentially the same prediction--that cuts would not happen quickly, if they happened at all during 2024--and my prediction has been correct through most of the year. Here's an excerpt from the quarterly Middleburg Markets Report, published in mid-January 2024:

Trading in options tied to overnight interest rates implies absolute certainty, according to the CME Group FedWatch Tool, that 2024 will see (1) zero additional hikes and (2) at least one cut in the key Federal Funds Rate. Very few occurrences in finance or macroeconomics have legitimate 100% or 0% probabilities, so it is worth questioning whether market participants' implied certainty is well-founded. ... Two (FOMC meeting) participants assessed that the current range would remain appropriate through 2024, and one even assessed that rate stability would remain appropriate through 2025 before declines would finally be appropriate in 2026.

My hosts also asked me about my recession forecasting model, which suggests about a 50% probability of a US recession in the next 12 months. Two factors are driving that high recession risk:

• The Near-Term Forward Spread--quite analogous to the slope of the yield curve, but more accurate for this purpose--has deteriorated over the last six months. That can happen for two reasons: (1) the economy is moving into recession, so market participants believe the Fed will cut rates to try to head it off, or (2) the economy is settling into a "soft landing," so market participants believe the Fed will cut rates because inflation pressures have subsided. I think the second explanation--the soft landing scenario--is the correct one, but my model cannot differentiate between them.
• Single-family housing starts (and permits) have also weakened considerably over the past few months, something that often precedes a recession. But housing starts data often give false signals: for example, similar weakness in the spring of 2023 caused the model's estimated probability of recession to jump to 60%--but then it jumped back down to just 8%. I think housing starts are likely to recover.

Certainly Fed Chairman Jerome Powell and other FOMC meeting participants have made strong statements giving themselves room to cut rates, and that creates a solid chance that the rate will be cut at this month's meeting--with 25 bps being more likely than 50 bps, in my opinion. But I'm comfortable with my prediction of no cut until November's FOMC meeting.