With Sticky Inflation and a Strong Economy, What’s the Case for Fed Rate Cuts?

According to Jerome Powell, the US central bank is “not far” from cutting interest rates. Monetary easing is typically used to combat a weak economy and a resultant slowdown in inflation. But there’s no hint of either in the current data. The US economy continues to outperform its peers by a wide margin and inflation has proved to be somewhat stickier than expected.

This cycle is fundamentally different. From the first pandemic-related rate cuts back in 2020 to the aggressive rate hikes in 2022 and 2023, nothing about this business cycle has been textbook. The Fed’s rate cuts won’t be predicated on below-target inflation or a recession in this cycle.

The goal now is to calibrate policy to achieve the vaunted soft landing. Bringing inflation down gradually while keeping the unemployment rate low seems possible with just the right touch.

The target for the fed funds rate is currently set at 5.375%, well above the central bank’s long-term neutral rate estimate of 2.50%. Even if policymakers decide to raise that estimate next week, the implications are the same: Rates need to come down before they get anywhere close to the neutral rate.

The difference between a typical rate-cutting cycle and the forthcoming one will not only come from the impetus to ease policy. The Fed is also likely to take a much more cautious approach than usual once it begins cutting rates. Without a severe recession or financial crisis on their hands, US policymakers can take their time delivering rate cuts.

That will come in some contrast to their peers at other central banks. The Bank of Canada, European Central Bank and Bank of England will likely begin easing monetary policy in June, the same time we expect the Fed to start cutting rates. However, Canada, the eurozone and the UK are all on the verge of recession.

As a result, rate cuts in those jurisdictions could be deeper. We expect the Bank of Canada to deliver more monetary easing than the Fed this year and next to combat the sluggishness in the domestic economy.

While borrowers in places like Canada will benefit from the extent of rate cuts, they’ll be disappointed to see how the local currency reacts. The US dollar is likely to remain strong against the Canadian dollar, assuming the rate-cutting cycle is less pronounced in America.