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It appears markets are shrugging off Fed Chairman Jay Powell’s warning that it is “premature” to talk about rate cuts.

CME data shows interest rate futures are currently pricing in about 1.25 percentage points of next year’s rate cuts. That equates to five rate cuts of 25 basis points each and could mean a cut at more than half of the eight meetings in 2024, or fewer deeper cuts.

The markets have certainly been pricing in a dovish outlook for weeks. And the most important change since Powell’s comments was slightly hawkish. The Fed funds futures market is leaning slightly more toward interest rates of 4 to 4.25 percent at the end of next year – before Friday, there was a higher market-implied probability of interest rates falling below 4 percent next year:

Still, the market’s implied probability of interest rates below 4 percent has increased significantly compared to a week ago.

This is what Morgan Stanley equity strategists have to say about the change:

In our view, the Fed hasn’t changed its guidance all that much over this period, but the bond market perspective is key. The net effect of this supposed reversal (in both directions) hurt bonds and stocks between July and October and has helped significantly since then. With 130 basis points of cuts now priced into the Fed funds futures market by year-end 2024, investors have set a high bar for implementing cuts.

When it comes to the question of pace, Deutsche Bank wants the Fed to cut interest rates by 175 basis points as early as the second half of the year. But strategists suggest the central bank could take a more proactive approach if both inflation and the labor market continue to slow.

The strategists add another interesting nuance to their call, which has to do with the “inertia” of politics. When central bankers use “inertia rules” to set interest rates, they take current interest rate trends and levels into account when making policy decisions. For “non-lazy rules,” ignore history and only look at recommended interest rates taking into account current economic and financial conditions. According to DB, if the US economy does indeed enter a recession, the central bank will likely move to a “non-sluggish” approach and cut interest rates quickly:

. . . The Fed is expected to begin cutting rates in June and cut rates by a total of 175 basis points by the end of the year – a more aggressive path than consensus and market prices. The case for cuts by mid-year is pretty clear in our forecast. By that point, core PCE inflation will have convincingly fallen below 3% year-over-year – shorter-term measures will be even lower – and the unemployment rate will have risen to near 4.5%. In fact, a set of projections from canonical, not inert policy rules [such as the classic Taylor Rule] – which are more relevant to us than inertia rules in a mild recession world where the Fed will not act slowly – would suggest that the Fed should cut rates sooner and more aggressively than our forecast expects

In fact, economic data shows that inflation is slowing worldwide. Still, inflation in the EU is closer to target than in the US, and it is notable that this unusually transparent Fed leadership remains so distant from the market in its communications.

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