US rate cuts delayed, not derailed

The Federal Reserve has been showing patience about starting policy easing, with recent comments from some officials suggesting the threshold for rate cuts in US has risen.

The timing of the first cut hinges critically on the inflationary trajectory. But we now expect two 25bps rate cuts, the first in September and the second in December. If inflation proves stickier than our forecast, the risk of just one cut in December or no rate cut at all this year would rise meaningfully. We stick with the view that the bar is extremely high for a future hike. It would take a strong acceleration in inflation, not just inflation being stuck above target, to justify a rate increase.

While one popular thesis has it that higher rates are leading to higher inflation, we believe rate hikes are still restrictive in aggregate. But there are good reasons to think the main channels of monetary policy transmission have weakened in the most recent tightening cycle. Structural factors related to the debt structure and specific factors related to the pandemic have boosted the economy’s resilience and contributed to the declining sensitivity of growth and inflation to monetary tightening.

Diminished transmission of monetary policy argues for a shallower easing cycle once the Fed starts, with the terminal rate settling above the Fed’s estimate of the long-run neutral rate. 

Where does our assessment of monetary policy leave our macro outlook? We expect US GDP growth to remain strong in Q2 before slowing to a solid, but slightly below-trend pace in H2, along with some moderation in the labour market. We expect consumption to slow as a cooling labour market weighs on disposable income, borrowing costs remain high, access to credit stays constrained, and the savings rate drifts higher. Government spending and investment are likely to slow as fiscal tailwinds fade. 

The balance sheets of lower-income consumers are deteriorating. Lower-income households are also sensitive to an adverse labour-market shock. But we expect they can manage their debt burden without causing broader distress.

Year-over-year core inflation readings will likely flatten out above target due to difficult base effects, but we expect core inflation to decelerate on a month-over-month basis. Wage growth should slow gradually, and inflation in vehicle insurance and financial services is likely to decelerate. We also expect some degree of residual seasonality that boosted Q1 inflation to reverse in H2. The process will be bumpy, and core inflation will remain above target in the coming year.