US economy – navigating back to neutral rates

Navigating the path back to neutral interest rates is a challenging task for the US central bank, the Fed. It seeks to balance both sides of the dual mandate –keeping inflation around the 2% target and a healthy labour market.

The concept of the “neutral” rate refers to the level of interest rates that neither stimulates nor restrains economic activity. Currently, the Fed estimate target the neutral rate to be around 3%

The Fed slash rates by 50 basis points

Last month, we discussed how the labour market is softening and why July’s jobs data figures looked sufficiently good enough to allow the Fed to make a cut in interest rates as the markets were expecting.

Since then, US inflation data was better-than-expected. US producer price inflation slowed to a six-month low of 1.7% in August, from a revised 2.1% in July and slightly under the 1.8% expected by the market. Over the month, wholesale prices rose by 0.2%, as expected.

Looking at the labour market, August’s jobs report showed that the US added fewer jobs than expected. With inflation subdued and heading towards its target, employment prospects now matter more to most Americans, as well as the central bank.

All in all, this led to a big move from the Fed last week and it announced a hefty 50-basis-point (bps) interest rate cut – the first since the Covid-19 pandemic started in 2020. The decision was taken by the majority of 11 to 1, with Michelle Bowman in favour of a 0.25% cut.

At the press conference, Chair Jerome Powell explained that this half-point cut “isn’t setting a new trend”, but is meant to keep the economy and labour market in good shape.

Read more: Fed makes bumper rate cut.

While the first rate cut has come slightly earlier than we anticipated, we stick to our more hawkish view. The market pricing currently implies an aggressive cutting cycle with the Fed reaching 3% next summer. While we broadly agree on the size of the cuts, we believe it will take the Fed up to 18 months to reach the terminal rate.

If the market expectations are to play out, the Fed would need to cut rates by 25 bps at every meeting between now and next summer, including some 50-bps cuts. Core inflation would need to fall well below target, and economic growth would have to weaken without any significant rebound in economic data. The Fed only meets eight times a year and the current target range is 4.75%-5.00%.

As mentioned last month, equity and bond markets will likely remain volatile until the path to neutral a policy rate becomes clearer.

The US election could throw a spanner in the works

The potential return of Donald Trump to the White House introduces further uncertainty on the direction of rates. An inflationary fiscal policy under Trump could lead to higher interest rates for a longer period to combat price pressures. This scenario could lead to a growth slowdown, requiring sharper rate cuts later in the economic cycle.

Additionally, Jerome Powell’s term as Fed Chair ends in early 2026. A Trump appointee might adopt a more accommodative stance, potentially altering the Fed’s policy direction.