The big question is what comes next after the Fed’s rate cut

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

There is virtually no doubt that the Federal Reserve will initiate an interest rate-cutting cycle next Wednesday. Indeed, recent data has supported the view that the central bank would have been better off doing so in July, at the prior meeting of the policy-setting Federal Open Market Committee.

Yet the sure expectation of next week’s rate cut comes with considerable analytical uncertainty about the endpoint for rates, the journey to that destination, the impact on the economy and for international spillovers. This uncertainty could easily catch bond investors off guard if liquidity conditions fail to loosen significantly.

While US economic growth has repeatedly proved to be much more robust than many had expected, the potential for continued “economic exceptionalism” must be weighed against the intensifying pressures felt by lower-income households. Many have exhausted their pandemic savings and incurred more debt, including maxing out their credit card. There is no agreement on whether this weakness will remain concentrated at the bottom end of the income ladder or migrate up.

And American exceptionalism is just one of the rugs that have been pulled from under the once-comforting anchors in analysing the US economy. The economy has also been robbed of the stabilising effects of unifying policy frameworks.

What was a long-term embrace of the “Washington Consensus” — the road to sustained economic prosperity involves deregulation, fiscal prudence and liberalisation — has given way to the expansion of industrial policy, persistent fiscal imbalances, and the weaponisation of trade tariffs and investment sanctions. Internationally, the consensus on ever-closer integration of goods, tech and finance has had to cede to a fragmentation process that is now part of a much bigger gradual rewiring of the global economy.

At the same time, the influence of the Fed’s forward policy guidance, another traditional analytical anchor, has been eroded by a mindset of excessive data dependency — this started to affect policymakers after the central bank’s big 2021 mistake of characterising inflation as transitory. The resulting volatility in the consensus view on markets, which has been moving back and forth like “narrative table tennis”, has fuelled a misalignment between the central bank and markets on basic policy influences.

Top Fed officials emphasise the continued relevance of both parts of the central bank’s dual mandate: to promote price stability and maximum employment. But markets have shifted violently in the past few weeks to price the Fed as a single mandate central bank, with a focus that has now pivoted from battling inflation to minimising any further labour market weakness.

At the same time, there is no agreement on how policy formulation should be affected by risk mitigation considerations typically associated with periods of economic uncertainty. Finally, there are many views on how and when senior Fed officials will transition from their excessive data dependency to a more forward-leaning view of policy.

While such uncertainties relate mainly to the inputs of interest rate decision-making, they have consequential effects on outcomes in three key areas: the terminal interest rate where policy is neither restrictive nor stimulative of the economy and the journey there; the extent to which rate cuts will translate into a bigger non-inflationary growth impetus for the economy; and the degree to which the Fed’s cutting cycle will open the door for an aggressive global cycle that also includes emerging countries.

This complicated analytical landscape is not reflected in how the US fixed income markets, which serve as global benchmarks, are pricing expectations for Fed policy. Government bonds markets are signalling high recession risk, looking for the Fed to lower rates by 0.50 percentage points next week or shortly thereafter, and to cut by a total of 2 points in the next 12 months. Yet credit markets are priced confidently for a soft landing.

These asset pricing inconsistencies can be resolved in an orderly manner as long as a significant further loosening of financial conditions, including sideline cash being put to work, offsets substantial bond issuance from the government and the ongoing contraction of the Fed’s balance sheet known as quantitative tightening.

The power of this was evident on Wednesday by the reversal of the large 0.10 percentage point rise in the two-year US yield caused by a slightly hotter monthly reading for core inflation. Yet this “technical” influence is a poor substitute for the restoration of growth and policy anchors. It is also an inherently volatile one.