Divergence disturbance

Timing and extent of the Fed's interest rate cuts this year may not align with market expectations

The United States Federal Reserve and the market are nearing consensus that the current cycle of interest rate hikes is coming to an end. However, there is still significant disagreement about the timing of future interest rate cuts.

Wall Street is optimistic about the prospect of interest rate cuts by the Fed and has already priced it in. According to data from the CME FedWatch Tool on Dec 1, the market expects the Fed to start cutting interest rates in March, with a potential cut of up to 125 basis points within the year. Fueled by this optimism, the US dollar index had fallen to 103.2 as of Dec 1, a decrease of about 4 percent from its peak in October, while the Dow Jones Industrial Average hit a new record this month.

In contrast to the market's optimism, the Fed's stance leans toward caution. Looking ahead, the divergence between the market and the Fed on interest rate cuts may once again create disturbances in financial markets.

The evolution of the current US inflation cycle is influenced by both supply and demand factors. On the supply side, the supply chain has largely recovered to pre-pandemic levels. Due to base effects, the downward pressure of supply chain improvements on inflation may weaken in the future and could even turn upward again due to new supply shocks. On the demand side, tight monetary policy will continue to suppress domestic demand in the US, but rising demand outside the US could exert inflationary pressure.

Specifically, two major supply factors and two major demand factors may have varying degrees of impact this year, leading to challenges on the pathway for the US to bring the level of inflation back to normal.

First, the aftermath of the major strikes in the US is gradually becoming apparent. Although the current wave of strikes in the US auto sector has temporarily ended, the direct and indirect impacts of the strikes may just start to emerge. If high inflation persists, the victories obtained by autoworkers from the strikes could set an example for other industries, and the possibility of more strikes, which could potentially push the levels of inflation even higher, cannot be excluded. However, with the power of the trade unions significantly weakened compared with the 1970s, whether more strikes lead to a spiral in the increase of wages and prices will take time to determine.

Second, supply gaps may lead to a slight rise in crude oil prices in 2024. In 2023, the prices of crude oil edged lower in choppy trade, mainly due to unexpected disruptions on the supply side. In addition to the increase in US crude oil production, Western policymakers have allowed Russian crude oil to continue circulating in the market by setting price limits, having seen an increase in Iran's crude oil exports. The oil production from these non-core OPEC countries has exceeded expectations, leading to a decline in crude oil prices. Looking ahead to the rest of this year, the oil supply from core OPEC countries is likely to remain at a low level, and uncertainties such as the unclear outlook of the Ukraine crisis pose questions about whether Russian oil can continue to circulate in the market. Geopolitical risks such as the escalation of the Israel-Palestine conflict also pose risks to oil supplies.

Third, a possible weakening of the US dollar may contribute to a rise in commodity prices. The US dollar index may drop considering the end of the Fed interest rate hikes and the shift to rate cuts this year, which could drive up global commodity prices and exert inflationary pressure on the US.

Fourth, China's macroeconomic policies may further stimulate global economic recovery and increase demand. China's total investment dropped in 2023 due to issues in the real estate sector and local government debts. However, the recent issuance of 1 trillion yuan ($139.4 billion) in central government bonds, the restructuring of local government debts and rollout of regulatory measures to support the financing of the real estate sector are indicators suggesting that the Chinese government is actively steadying economic growth and spurring recovery. Looking ahead to the rest of this year, China could see the stabilization and growth in investment with the defusing of financial risks and the implementation of pro-growth policies. China's macroeconomic policies and economic recovery may boost global demand.

The focus of the Fed's monetary policy will shift from a primary focus on containing inflation to an equal emphasis on cutting inflation and creating jobs. However, if the unemployment rate in the US does not rise significantly, two factors may result in delays in the Fed's rate cuts compared to the market curve.

First, the path to bring the level of inflation back to normal may not be smooth sailing. In this process, if the Fed hints about interest rate cuts too early, it may lead to a significant rise in financial asset prices, a rebound in business investment, and an increase in consumer spending. This could result in a more solid foundation for inflation or a rebound in inflation, making it more difficult for policymakers to attain their target of controlling the level of inflation at around 2 percent.

Second, the Fed needs to rebuild its credibility, making it more inclined to cut rates later than expected. The Fed's misjudgment of the inflation situation in 2021 damaged its credibility. To rebuild its credibility, the Fed may lean toward a more hawkish stance. The timing and extent of the Fed's interest rate cuts this year will depend on specific economic data, and the possible divergence between the Fed's actual actions and market expectations may once again increase disturbances in financial markets.

Xu Qiyuan is a senior fellow and deputy director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. Yang Zirong is an associate researcher of the institute. The authors contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.

Contact the editor at editor@chinawatch.cn