The September FOMC “dot plot” shows just 50 basis points worth of rate cuts in 2024. This has widened the gap between the Fed’s signals regarding what it intends to do and what we believe it should be doing next year. In our view, easing inflation warrants more aggressive rate reductions. We worry that overconfidence in the soft-landing scenario could turn the soft landing itself into something far less benign.
The US economy has shown a surprising degree of resilience in the face of rising interest rates. Given this has been the most aggressive monetary tightening cycle in decades, it is remarkable that we have not seen more economic pain so far. The question now, though, is whether the Fed can make the soft landing stick.
A fierce debate has taken hold not only about how high the Fed should go in the short term, but also about whether and to what extent the neutral interest rate, i.e., the rate at which monetary policy is neither stimulative nor restrictive, has shifted higher.
For our part, we draw a conceptual distinction between a slow transmission of monetary policy due to exogenous temporary factors and a sustained shift higher in the level of the neutral policy rate.
In our view, the current US monetary policy stance is highly restrictive. The impact of that restrictiveness, though, has been blunted by factors such as residual excess savings, the fixed-rate nature of the US mortgage market (Figure 1), delayed corporate debt refinancing schedules, i.e., no immediate refinancing “wall” (Figure 2), and substantial lingering fiscal boost.
Admittedly, to the extent that exogenous factors slow the transmission of monetary policy tightening, the de facto implication is that the Fed needs to push rates higher to achieve the desired dampening of demand.
In other words, at the moment, when rates are on the upswing, it matters little whether hikes are delivered on the basis of slow policy transmission or on the basis of a higher neutral rate. That distinction, however, carries important practical implications during the rate cutting phase of the cycle.
As we see it, acknowledging exogenous factors as key variables that influence the intensity of restraint from the high interest rates should make monetary policy nimbler as it builds in faster policy reactions to changes in those factors.
This means, if policymakers believe the neutral rate is little changed, there would be a preference to respond fairly quickly to improving inflation data when the factors slowing the transmission of monetary policy lose their potency. In turn, this reduces the risk that policy is maintained at exceedingly restrictive levels for longer than necessary.
To ensure that the soft landing sticks, we believe the Fed should pre-emptively calibrate rates lower as inflation recedes in 2024. In our view, the factors currently slowing monetary policy transmission in the US will moderate — not overnight, but in the coming quarters. When that happens, the higher rates that so far have caused little pain will truly begin to sting.