Why the case is growing for a Federal Reserve interest rate cut before year end

The Fed interest rate policy path is pretty clear for the next few months of Federal Reserve FOMC meetings. A 25 basis point hike, or quarter-point increase, is coming this Wednesday, and likely one more at the following meeting, but after that, the disagreement between the market and the Fed begins.

That’s according to the latest CNBC Fed Survey, which finds among top economists and investors a view of the Fed’s course that helps to explain why, in addition to recent data showing progress against inflation, stocks have been in rally mode to start the year.

One hundred percent of respondents to this week’s CNBC Fed Survey expect a 25 basis point hike on Wednesday, and 82% say the Fed will hike by another 25 basis points at the subsequent FOMC meeting in March. That means 50 basis points is “baked in,” but after that, a reversal in Fed course taking rates back below 5% is a bet that is catching on with more market participants. The Fed will get to 5%, but quickly start to retreat so that the year-end rate is going to be 4.6%, according to the Fed Survey. That’s an outlook that matches the recent action in the futures market, which is at 4.5%.

Why will the Fed retreat? For one, inflation is coming down across multiple indicators, whether the goods inflation that soared first during the pandemic, or the wage inflation that is a top concern of Fed Chair Jerome Powell now. And more investors and economists expect inflation will continue to come down meaningfully in the months ahead, though the Fed won’t say it and has to stick with its “fight is far from over” stance.

The latest data this week has been encouraging, from the Employment Cost Index showing wage growth easing to the Fed’s preferred measure of inflation cooling, and all while GDP is holding up better than expected.

That’s the idea of the “soft landing” that is filtering into the Fed Survey as it has into stocks throughout January, which saw the darling of the Covid bull market, Cathie Wood’s ARK Innovation ETF, post its best month ever. But consumer spending is down over the past few months as well, complicating the picture as far as progress versus inflation, versus an economy tipping into recession.

Federal Reserve Board Chairman Jerome Powell holds a news conference following the announcement that the Federal Reserve raised interest rates by half a percentage point, at the Federal Reserve Building in Washington, U.S., December 14, 2022. 

Evelyn Hockstein | Reuters

The central bank is cognizant that, no matter what it signals to the market about staying the course, an interest-rate induced economic slowdown can quickly turn into a recession and layoffs mount sharply — and the hard landing risk that comes with a more aggressive monetary policy become reality before there is sufficient time for the Fed to switch gears.

Fear of recession dipped in the latest Fed Survey, but it’s still elevated, with 51% of respondents expecting a recession. It had been north of 60% in recent surveys, but make no mistake, the 51% is still much higher probability than typical, with average probability of recession at 20% during more normal times. Some respondents merely pushed out their recession forecast to later in the year.

Expectations for a rise in unemployment are also not quite as severe as would be the case in a sharp recession, with survey respondents expecting a rise of one percent to 4.5% unemployment, which all things considered, would be far from a worst-case scenario.

The Fed also has the benefit of a lot more inflation data to come after this week’s FOMC meeting before they meet again in late March, a comment made by several Fed presidents in recent CNBC interviews.

Federal Reserve Governor Christopher Waller said in recent remarks that “we still have a considerable way to go toward our 2% inflation goal, and I expect to support continued tightening of monetary policy.” He also told CNBC’s Steve Liesman that, “The market has a a very optimistic view that inflation is just going to melt away. The immaculate disinflation is going to occur. We have a different view. … It’s going to be a slower, harder slog to get inflation down and therefore we have to keep rates higher for longer and not start cutting rates by the end of the year.”

Waller did say it is possible to have a soft landing and bring down inflation without a worst-case outcome in the labor market.

The Fed Survey doesn’t have a positive outlook on growth for 2023, but isn’t forecasting negative growth either. Right now, GDP is forecast to be at “the zero line” for each quarter this year (0.375%), before a modest snapback in 2024 at a little over 2%. And of course, that close-to-zero GDP can become negative very quickly if there is any shock to the economy, such as sharply higher energy prices, among the sources of high inflation that have retreated from recent peaks. ExxonMobil announced record profits for 2022 on Tuesday, but crude prices are down in seven of the past eight months.

Members of the CNBC CFO Council met on Tuesday morning to discuss the Fed Survey and their outlook on the economy. Here are some of the economic issues raised by chief financial officers at top companies on the call with CNBC’s Liesman. The call is conducted under Chatham House rules so CFOs can speak freely.

Price increases are getting more strategic

One of the key issues in the fight against inflation is price increases passed along to the consumer. While goods inflation has rapidly come down as the supply chain kinks were worked out and commodities inflation has eased, companies don’t just give back all price gains to consumers. But one consumer CFO did say that the way price increases are “pushed through” is becoming more strategic as opposed to across-the-board. For example, a firm may offer more discounts for orders made through apps or orders that are bundled, versus in-store purchases.

The consumer electronics spending market is dead

Several CFOs commented on the call that the area where the consumer slowdown is sharpest is in electronics, with no one buying cellphones, laptops or any personal electronics.

“We are clearly seeing that segment of the market hit pretty hard,” said one CFO. Certain segments where computer components are key, such as autos, remain stronger if softening, but that is more industrial sales than consumer sales as far as the technology supply chain. “The consumer has been rough for a few quarters,” the CFO said.

That’s not a surprise, with recent earnings from technology companies showing weakness across markets — semiconductor firms revealing a glut of chip inventory, led by a “horrible quarter” from Intel, to PC market players such as Microsoft showing that the spike in personal electronic consumption during the pandemic is over, though that’s been a trend developing over more than just one quarter. Apple is expected to show its first revenue decline since 2019 when it reports earnings on Thursday. 

China’s reopening is key to global economy

Consumer electronics is among the areas where all eyes are on China and companies waiting to see if it bounces back this year in a reopening period.

That’s less about the Chinese factories producing more to balance supply and demand (more companies are moving production elsewhere in Asia and around the world) and more about Chinese consumers with pent-up savings and a desire to spend stimulating growth.

While China’s impact on inflation can be double-edged, the global economic picture is suddenly not looking as grim as it had just a few months ago, with the International Monetary Fund this week downgrading the risk of a global recession and upping its growth forecast.

CFOs were split on exactly when the Chinese economy really starts accelerating during 2023, but one CFO was confident in expressing belief in a significant change from what has been a “massively deflationary” environment over the past few years. 

Need to pay higher wages is lessening, at least in tech

Fed Chair Powell is focused on wage growth more than any other factor, and the need to bring down labor demand to a level closer to labor supply as a way to lessen that pressure. Success in that effort is a key signal to the Fed that it is winning the fight against inflation, and while the Employment Cost Index came in slightly below expectations in Tuesday’s latest quarterly data, it is still running hot. 

The tech sector layoff headlines should not be taken as a sign that the overall labor market isn’t strong. But tech job cuts and the hard times for the venture capital-funded startup economy are one area of the economy where there are signs of a less-tight labor market.

“I was losing people to SPACs and $2 million in options for a 26 year-old,” said one CFO. “There is ‘less stress in the labor market’ but it is still tight, wages are still higher,” the tech CFO said. However, when forecasting merit pay raises for this year, the pool is not growing at the pace it had been growing at over the past two years. It’s still higher, but at least coming closer to the long-term average.

In addition, several CFOs said voluntary attrition rates have come down “pretty markedly” — to about half of the rate they had been at peak. At least in tech, employees are becoming a little less bold about asking for a raise and knowing if they don’t get it, they can walk and find another job for more pay.

The layoffs within tech keep coming, with PayPal the latest firm to announce job cuts. But in January alone, Google released a plan to lay off more than 12,000 workers, Microsoft identified 10,000 job reductions, and Salesforce began laying off 7,000 workers.

Half the level of turnover, less time to fill open jobs — some CFOs indicated they were benefitting from Big Tech’s layoffs in their hiring — and less pressure on wages and signing bonuses are all positive signs for employers, though it isn’t clear how much that dynamic is spreading beyond the hard-hit tech labor market.

The latest Fed Beige Book report said of labor markets, “wage pressures remained elevated across Districts, though five Reserve Banks reported that these pressures had eased somewhat.”