Is the Market Overestimating U.S. Interest Rate Cuts? Amid recent developments in the U.S. economy and inflation data,
an important question arises regarding market expectations for interest rate cuts. Could these expectations be overblown?
In this article, Mohamed A. El-Erian highlights the impact of recent inflation data on market trends and Federal Reserve expectations,
as well as whether the current scenario suggests significant interest rate cuts or if these expectations need to be reassessed.

Read on to learn how the markets are reacting to these developments and what they mean for the future of the U.S. economy.

Content

Inflation Data

Interest Rate Cuts

Supporting the Latest Inflation Data

Soft Landing

Inflation Data

Recent inflation data for both the Producer Price Index (PPI) and the Consumer Price Index (CPI) have reassured markets in two significant ways.

They confirm continued progress in the battle against high price increases
and support the ongoing shift in the Federal Reserve’s focus from inflation to employment.
While this opens the door for a potential rate cut in September,
it does not fully support the final interest rate target that the market expects,

which is about half a percentage point lower than necessary.

The PPI data released on Tuesday was below analysts’ consensus,
both overall and excluding the volatile food and energy categories.
This positive news led to a significant rise in the stock market and a noticeable decline in government bond yields.

Interest Rate Cuts Are Almost Certain

Market reactions were further reinforced by Wednesday’s CPI data,

which aligned with analysts’ expectations.
The core measure increased by 2.9% in July compared to the same period last year,
marking the first time since 2021 that the figure showed a “2.” Based on this inflation data,
it seems almost certain that the Federal Reserve will begin a cycle of interest rate cuts in September,
likely starting with a 25 basis point reduction (although a 50 basis point cut is not entirely out of the question).

At first glance, this supports the market’s expectation of a cumulative 200 basis point cut,
bringing the federal deposit rate down to 3.25%-3.5% over the next twelve months.

Two Ways to Support the Latest Inflation Data

For these expectations to materialize, the data released this week must be supported in two main ways.
First, Federal Reserve Chair Jerome Powell’s remarks at Jackson Hole must be supportive and comprehensive,

including his views on the neutral interest rate that neither stimulates nor constrains the economy,

the path to achieving that rate, and how the Fed plans explicitly to achieve the sustainable 2% inflation target.

Second, the Federal Reserve must begin the anticipated rate-cutting cycle in mid-September,
in line with market expectations. Without these two foundations, we risk repeating the market crisis during the first three days of August.

Given the slowing economy, these reassurances are crucial for maintaining a stable

and a well-functioning market that avoids the negative consequences of troubling economic volatility.

Additionally, they will help ensure organized alignment with market expectations,
especially as some analysts have recently revised their assessments
of recession risks and their related forecasts for Fed actions.

Soft Landing Is the Most Likely Scenario

Despite easing concerns about inflation, uncertainty is growing around the Fed’s mission of maximum employment.
I still expect a 50% chance of a soft landing.

Still, the 35% likelihood of a recession is too significant to ignore
(the remaining 15% suggests an economy growing moderately due to a series of favorable supply-side shocks).

The recession risk scenario is susceptible to adverse external developments,
such as escalating conflicts between Hamas and Israel, Russia and Ukraine, or both.
Domestically, the Federal Reserve’s delay in taking appropriate actions could exacerbate these risks.
Such risks could harm the only current driver of the economy—stable income from employment.

Combining the probabilities of 35%, 50%, and 15%,
my expectation for the long-term neutral interest rate and the likelihood of a balanced inflation rate around 2.5%

rather than the Fed’s 2% target,
suggests that the market’s expectation of a 200 basis point rate cut may be overly optimistic.

My expectation of a 150 basis point Fed rate cut over the next twelve months
will change if the most likely macroeconomic scenario shifts from a soft landing to a recession.
However, most of us would prefer to avoid this outcome,

even if it means that the market’s current expectations for Fed actions are incorrect.

Is the Market Overestimating U.S. Interest Rate Cuts?

Is the Market Overestimating U.S. Interest Rate Cuts?

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