Schroder Investments: Is the Federal Reserve playing with fire?

The Zhitong Finance App learned that Schroder Investment released a research report saying that due to the uncertainty of “neutral” interest rates, the Federal Reserve's aggressive interest rate reduction cycle may reignite the risk of inflation. According to Schroder, the risk of underestimating a neutral interest rate is greater than the risk of overestimating it. This requires a more careful and relaxed pace than currently anticipated in the bitmap. As a result, the current expectation remains that the Commission will cut interest rates by 1/4 per cent in March and June 2025, respectively, and then suspend the pace of interest rate cuts to assess the effectiveness of the easing policies already implemented at that time (cumulative interest rate cuts of one and a half percent). If inflation then remains under control, this should open the door for further moderate monetary policy relaxation in 2026.

When the Federal Reserve starts a cycle of cutting interest rates by half a percent, it usually attracts the attention of the investment market. The US implemented the same measures in January 2001 and September 2007 (that is, three to four months before the US economy fell into recession), and at the beginning of the global outbreak in March 2020. Due to the appearance of this behavior, the bank had assumed that the Federal Reserve would follow the mid-term adjustments of 1995, 1998, and 2019. In those three adjustments, a slowdown in economic growth (rather than a recession) prompted the Federal Reserve to start cutting interest rates with the usual one-quarter cut.

Schroeder said that only the US Federal Open Market Committee (FOMC) chose a more aggressive half-cut, which was in line with the expectations of 91 of the other 100 economists surveyed by the bank and institutions. Federal Reserve Chairman Powell tried to position this as a “recalibration” at the press conference. He mentioned this no less than nine times, while stressing that there is a long-term and variable lag in the role of monetary policy. This suggests that for the current stage of the economic cycle, interest rates are too tight, and the Federal Reserve hopes to return to neutral interest rates as soon as possible.

While Powell's rationale is understandable, it is thought that such an aggressive pace of monetary easing is unnecessary. Neutrality is an imprecise concept. It is not a measurable number, but a theoretical interest rate level that is neither too tight nor too loose to return economic growth and inflation to a stable and predictable track. However, if an aggressive cycle of interest rate cuts occurs, and the US economy is more resilient than expected by policymakers, US monetary policy may eventually be too loose, or fall below neutral levels, rekindling the embers of inflation.

Federal Reserve Governor Michelle Bowman (Michelle Bowman) seems to have the same concerns. She supported a quarter-percent interest rate cut at the September interest rate meeting. She believes that the US labor market is still close to full employment, even though recent signs of weakness have been affected by data calculations and immigration issues. Although inflation has clearly abated, she believes it's too early to declare victory, so it's best to move at the right pace to avoid unnecessarily stimulating demand.

But Bauman is clearly in the minority. Federal Open Market Committee members forecast a “bitmap” of interest rates at the end of 2024 that interest rates will be cut by another half of the year based on the current federal funds rate range of 5.00-4.75% by the end of the year. Although this is a bit excessive, it is best not to go against the Federal Reserve. As a result, the Federal Reserve is expected to cut interest rates by a quarter of a percent in November and December, respectively. Previously, it was expected to cut interest rates only in December. Coupled with the sharp interest rate cut in September, this cut interest rates by half more than previously anticipated, prompted the bank to raise the already higher than agreed 2.1% growth forecast for 2025.

Schroder's risk on interest rate predictions is downward. It is currently unclear whether the investment market caused the Federal Reserve to cut interest rates by half in September; even so, the Commission should not turn this method into a habit. The latest forecast includes an “aggressive interest rate cut” scenario: in this case, concerns about economic growth prospects persuaded the Commission to implement the aggressive rate cuts expected by the market. The bank believes that this will eventually cause the pace of inflation to accelerate again and force the Commission to start raising interest rates again.