Low inflation, interest rate cuts and no recession in 2024? Not so fast

Last week, the United States Federal Reserve, the world's most influential central bank, surprised investors by announcing the end of its interest rate-raising campaign. They also projected a decrease in borrowing costs by three-quarters of a percentage point next year. This was a significant shift from the previous narrative around monetary policy. Jerome Powell, the Fed chairman, had previously stated that it was too early to speculate on the timing of rate cuts. However, on December 13, he revealed that the Fed had discussed the initiation of easing policy. This policy shift had a significant impact on the markets. Powell also expressed confidence in averting a recession, reinforcing the perception of a 'soft landing' for the US economy. According to Bloomberg data, the markets experienced their best 'Fed day' since 2009, with all major asset classes gaining at least 1 per cent in response to the Fed's dovish pivot.

The results of Bank of America's latest poll of global fund managers, published on Tuesday, showed a highly positive sentiment. Two-thirds of respondents anticipated a soft landing for the global economy, 80 per cent expected lower inflation, and a record percentage believed government bond yields would be lower a year from now. There is much to be optimistic about, particularly in the US. Headline inflation in the euro zone has fallen to just 2. 4 per cent, slightly above the European Central Bank's target and down from over 10 per cent a year ago. In the United States, inflation stands at 3. 1 per cent, lower than Britain's 3. 9 per cent. Surprisingly, the much-anticipated recession in America did not materialise. The US consumer has demonstrated remarkable resilience, bolstered by a robust labour market.

However, there are also numerous reasons for caution. Investors seem to be overreacting to positive signals while downplaying or ignoring negative ones. There are three reasons why the 'Goldilocks scenario' that many fund managers are betting on – lower inflation, aggressive rate cuts, and decent growth – appears unlikely. Firstly, while leading central banks maintain that the battle against inflation is not yet won, markets are behaving as though it is. Many investors now seem to believe that inflation was transitory, even though it proved more persistent than expected. While this was the case with goods inflation, services inflation remains stubbornly high. Secondly, the path to a soft landing is a narrow one. History shows that it is challenging to suppress inflation without causing a rise in unemployment and a steep downturn. Growth is already decelerating. Although the US economy remains relatively resilient, the euro zone is likely to have slid into a technical recession – two consecutive quarters of contracting output – in the final months of this year, while Britain has been stagnating for some time. Even in the US, the Fed now appears more concerned about growth than inflation. Powell stated that he was mindful of the risk of maintaining high rates for too long and that the Fed would need to begin easing policy well before inflation reached 2 per cent to prevent economic activity from slowing too sharply. This increased sensitivity to growth has led bond investors to price in aggressive rate cuts typically associated with a recession. This raises two troubling questions. Why did Powell not push back against market expectations of a dramatic policy loosening? More worryingly, is the Fed under pressure to cut rates earlier than might otherwise be justified to aid US President Joe Biden in defeating Donald Trump in next year's presidential election, thereby undermining its independence?

Thirdly, expectations have consequences. The Fed's unexpected policy shift has led to a further loosening in financial conditions. The yield on benchmark 10-year US Treasury bonds has fallen to 3. 8 per cent from about 5 per cent at the end of October, the US dollar continues to weaken, and US stocks have hit fresh highs while spreads on corporate bonds have narrowed. Looser financial conditions stimulate economic activity, making it more challenging to control inflation and potentially forcing the Fed to tighten policy further. Torsten Slok of Apollo Global Management noted in a report published on Tuesday that 'the Fed pivot last week complicates the Fed's goal of getting inflation back to 2 per cent' and that 'as we enter 2024, the pendulum will soon swing back from a dovish Fed to a more hawkish Fed'. The Fed has so far managed to avoid a hard landing, which is commendable. However, soft landings are a rarity. The fact that markets are expecting the smoothest of touchdowns next year should serve as a warning.