Economics Update April 2024 - Interest rates and financial markets: between expectations and economic reality

The expectations of the financial markets regarding the Federal Reserve's interest rate policy decisions are a decisive factor for the development of long-term interest rates. An analysis of interest rate expectations over the past few months shows strong fluctuations, although the fundamental situation has not changed significantly: Six months ago, the markets believed that the Fed would leave its key interest rate at the level it had reached for quite some time and make a total of three rate cuts totaling 75 basis points over the course of 2024. Three months later, at the start of 2024, the first rate cut was expected as early as March and it was anticipated that a total of six or even seven rate cuts would follow by the end of the year. Now, at the start of the second quarter, market expectations are exactly where they were six months ago.

Fed's interest rate policy strictly data-based

Then as now, the US Federal Reserve's main objective is to reduce inflation to the targeted level of 2%. In doing so, it follows a data-based approach and always emphasizes the significant uncertainties regarding the achievement of the target. However, while the markets' interest rate expectations contain an element of speculation, inflation has largely developed in line with economic analyses - and was therefore by no means surprising: in October, the inflation rate, measured by the deflator of private consumer spending (the Fed's preferred inflation measure), was 3.4%; by February, this figure had fallen to 2.8%, which is still noticeably above the target value of 2%. There were both good theoretical arguments and ample empirical evidence for the expectation that the "last mile", i.e. reducing inflation from 3% to 2%, would be the most difficult to manage. On the one hand, base effects that were still favoring the decline in inflation in 2023 are coming to an end - the lowest-hanging fruit has now been harvested. Secondly, the continued positive overall economic demand is allowing many companies to increase prices. The latter is particularly evident in the services sector, with the result that annual price increases here still amount to 5%. The markets' euphoria over interest rate cuts in the meantime was based on continuing the favorable inflation data from October to December and ignoring existing risks. This approach was encouraged by positive comments from Fed Chairman Powell in December. The inflation data for January and February were a disappointment compared to the high expectations, but were in line with the fundamental economic findings overall. Both the rise in the yield on 10-year US government bonds in the fall to up to 5% and the rapid fall to 3.75% within a few weeks were therefore clearly exaggerations that were not covered by economic reality.

Slight recession or second wave of inflation?

The deflator for private consumer spending could actually fall to around 2.5% by the middle of the year, allowing the Fed to make the widely anticipated first interest rate cut. However, there are considerable uncertainties for the second half of the year: For the inflation rate to fall sustainably, overall economic demand would have to decline significantly, which would very likely result in a moderate recession in the US economy at the end of the year. The Fed is likely to react to this by cutting interest rates more sharply than the markets are currently expecting. In the alternative scenario of a continued robust economy, on the other hand, there is a threat of a renewed rise in prices and thus the feared second wave of inflation. In this case, the Fed could be forced to reverse its interest rate cuts, which would lead to a recession all the more. Regardless of which scenario ultimately prevails: Either way, it is unlikely that things will turn out as the markets currently expect.