AFTER THE PARTY COMES THE HANGOVER: Why these strategists see the Fed cutting rates within 3 years

Ezra Shaw/Getty ImagesIt’s all looking good… for the moment.
  • Jerome Powell, US Federal Reserve Chair, says the the best way forward, for now, is to keep gradually raising the federal funds rate.
  • The Commonwealth Bank, like most others, thinks the Fed will do this four more times in the year ahead.
  • However, driven by the likelihood of a sharp economic downturn, it expects the Fed will be cutting rates, not hiking, by early 2021.

“With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that — for now — the best way forward is to keep gradually raising the federal funds rate,” says Jerome Powell, US Federal Reserve Chair, in a testimony to the US Senate Banking Committee on Tuesday.

Reinforcing the view that with the job market is strong and inflationary pressures building, the Fed intends to continue the process of gradually normalising interest rates despite heightened uncertainty towards the global trade outlook.

Powell’s “for now” caveat, in particular, has received plenty of attention across markets, seeing speculation over just how long the Fed’s tightening cycle will last bubble to the surface again.

Joseph Capurso, Senior Currency Strategist at the Commonwealth Bank, thinks he knows the answer.

June 2019, to be precise.

“We have upgraded our US GDP forecast for 2018 from 2.6% to 2.7% and for 2019 from 2.1% to 2.3%,” he says.

“On our forecast, the FOMC will increase the Funds rate four more times to 2.75-3% by June 2019, potentially putting the Funds rate 0.5% above neutral.”

So four more increases in the Fed funds rate in the year ahead, leaving policy settings slightly restrictive given the economy is likely to be growing faster than its potential growth rate of around 1.5-2% per annum, placing upward pressure on wages and inflation.

Capurso’s view is not dissimilar to many economists and those in financial markets at present.

However, it’s over the medium-to-longer term where his views diverge from the pack.

He thinks that rather than leading to a gradual deceleration in economic growth, the downturn will be quite sharp, especially given the level where policy settings become restrictive is likely to be significantly lower than the past.

“We expect US GDP growth to decelerate to 2.3% in 2019, 1.5% in 2020, and 1.3% in 2021,” he says, adding that his forecasts are below that of US economists who see growth slowing to 2.4% next year and 1.9% in 2020.

“US economic growth will slow over the next few years because of fading US fiscal stimulus, a tightening of monetary policy, both by higher interest rates and a smaller Fed balance sheet, modest business investment and slowing household consumption.”

Capurso this view reflects that the level where the real Fed Funds rate — the nominal rate less inflation expectations — becomes restrictive for economic activity has fallen materially in the past three decades, from over 4% in the early 1980s to around 0.5% today.


Even with an expectation the Fed funds rate will peak in only slightly restrictive territory, given the growth slowdown will likely lead to weaker wage and inflationary pressures, Capurso doesn’t expect that it will remain there for long.

“We expect slowing economic growth and easing wage and price inflation to prompt a response by policy makers in 2021,” he says.

Policy easing, in other words.

“We have pencilled in the start of the FOMC’s next monetary policy easing cycle in the first quarter of 2021.

“We expect the FOMC to cut the Funds rate by around 2.0 percentage points to a range of 0.75-1.0% by the end of 2022. However, the risk is the rate cut cycle is front-loaded into 2021.”

While that seems a lot, Capurso says it would be actually very small by the past standards, and consistent with the view that US economic growth will slow rather than contract.

“We expect the FOMC to continue its practice of adjusting the Funds rate in increments of 0.25% and retaining the target band width of 0.25%,” he says.


Alongside the potential for eight 25 basis point cuts to the funds rate, Capurso says the FOMC will likely cease reducing the size of its balance sheet — known as quantitative tightening — in the early parts of 2020, leaving it around $US3.25 trillion, well above the $US900 billion level it stood at prior to the Great Recession.

However, while he expects the Fed will cease allowing maturing investments to run off its balance sheet, Capurso doesn’t expect the Fed will look kick start another round of quantitative easing, pointing out that while it remains a policy option, it would likely prefer to use rate cuts, rather than asset purchases, to cushion the economic downswing.

As for the biggest risk to his call, Capurso believes it comes from fiscal policy, especially ahead of the next US Presidential election scheduled for late 2020.

“The softer economic outlook for the US in 2020 and 2021 may encourage President Trump to apply some more fiscal stimulus in the lead up to the November 2020 Presidential elections,” he says.

“As a consequence, [this] may encourage the FOMC to delay starting a rate cut cycle.”

There’s lots of moving parts and assumptions in Capurso’s forecasts, as there are with any view towards the future.

However, if one thing is certain, it’s that it promises to be a few interesting years ahead.

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