‘Placeholders For When Something Goes Wrong’

There are a laundry list of reasons to cast a wary eye at the rate cuts traders currently expect from the Fed in the back half of 2023.

The most obvious is that inflation isn’t especially likely to be on a sustainable path back to 2% anytime soon, a condition officials have made clear must be met before the Committee would consider taking its foot off the brake, let alone tapping the accelerator, however lightly.

We all know goods inflation is receding and if you’re inclined to predict that price growth in core goods will turn negative on a 12-month basis in 2023, nobody would suggest you’ve lost your mind. In fact, that outcome seems more likely than not. The problem is services inflation, which is likely to stay elevated for most of the year.

But another key consideration is that the neutral rate isn’t something anyone can pinpoint with precision, which by extension means “sufficiently restrictive” is a fuzzy concept. By their own admission (and you can’t avoid admitting it, because we’re dealing with theoretical thresholds that aren’t observable), the Fed is fumbling around in the dark. You have to pass “neutral” to get to “restrictive” and you’ll only know “sufficiently restrictive” by observing trends in realized inflation. This isn’t a science. It’s not an art either. It’s economics.

For now, the Fed believes “sufficiently restrictive” is probably somewhere between 5% and 5.25%, and policymakers have been adamant that once they figure out where sufficiently restrictive is, policy will probably need to loiter there for at least six months. If you ask Goldman, all of this ambiguity is itself a reason to doubt the prospect of rate cuts in 2023.

“We are doubtful that the goods-driven decline in inflation that we expect would be sufficient to give the FOMC confidence that inflation is moving down in a sustained way, which Powell has said is the criterion for cutting, but more than that, we remain skeptical that the FOMC will cut just for the sake of returning to neutral because we suspect that the Fed leadership does not have enough confidence in its neutral rate estimate for it to exert much gravitational pull on the policy rate,” Alec Phillips and David Mericle said.

Goldman expects the Fed to hike in 25bps increments over the next three meetings and then hold terminal for the remainder of 2023. The market, by contrast, expects at least 50bps worth of easing by this time next year.

This all may sound repetitive or tedious, but this particular bit of nuance is important. Goldman views the idea of rate cuts aimed at fine-tuning restrictive policy with skepticism. The Fed doesn’t know where neutral is. Policymakers expect core inflation to end 2023 at 3.5%, well above target. Tinkering with rates (e.g., getting to 5%, then cutting by 25bps almost immediately in an effort to get it “just right,” so to speak) could prove asinine at best, and counterproductive at worst.

Traders seem to believe the Fed is anxious to cut rates at the first sign of daylight “because markets,” if you will. But this Fed has made it clear that “because markets” isn’t a viable rationale anymore, or at least not until there’s enough air cover on the inflation front to make a return to the “wink, wink” policy-markets nexus possible.

Unless and until inflation moderates significantly, ideally driven by services and accompanied by evidence of labor market rebalancing, the only path to rate cuts is recession, in Goldman’s thinking. The bank was forthright about that, calling recession (or the imminent threat of recession) “the more natural path” to easing, as opposed to some inclination on the Fed’s part to tweak and tinker just to say they did.

“If tighter monetary policy succeeds in convincingly reducing inflation, we expect the FOMC to just leave the policy rate unchanged until something goes wrong,” Phillips and Mericle wrote.

Goldman has cuts penciled in from 2024 to 2026, but the bank said the timing shouldn’t “be taken literally.” Instead, those theoretical, distant cuts are “placeholder[s] for an uncertain future date when something goes wrong.”