Perspectives : Markets & Economy | June 15, 2023

We likely won’t see Fed rate cuts until 2024

Read time: 4 minutes

Since its June 14 monetary policy announcement, the Federal Reserve continues to wrestle with whether another interest rate hike is warranted in its fight against inflation. Financial markets go a step further, wagering on rate cuts in 2023. Vanguard economists using a machine-learning model make the case for no rate cuts this year.

Based on pricing for bonds and futures contracts, the markets expect the Fed to cut its policy rate by more than half a percentage point by year-end. But that’s probably unrealistic, according to Asawari Sathe, a Vanguard senior economist.

“We believe inflation will continue to moderate but remain above 3% through year-end, and unemployment will trend higher to a still reasonable 4.5%,” she said. “In that scenario, the Fed cutting its policy rate this year is unlikely.”

In fact, Vanguard’s model anticipates that the Fed won’t be in a position to cut rates until the middle of 2024. To get inflation back toward the 2% target, there is currently a 38% probability of the Fed increasing rates in the near future, a 35% chance of a rate pause or hold, and only a 27% chance of a rate decrease.

“Our model suggests that it’s nearly three times as likely that the Fed will raise its target for the federal funds rate or keep it on hold this year than that it will cut rates,” Sathe said. “Our model’s output underscores our conviction that the Fed’s fight against inflation hasn’t yet reached an inflection point.”

A cut in the federal funds rate target is unlikely until 2024
Two charts on top of each other. The top chart has a line showing the actual federal funds rate from mid-2021 through May 2023, then a projected Fed funds rate thereafter. The line starts near zero in 2021, then rapidly starts rising in early 2022 before hitting 5.25% in May 2023. The projected line rises to around 5.63% by July 2023 before it starts to gradually fall around June 2024. A second chart with three lines shows the probabilities, respectively, of a rate increase, a rate hold, and a rate decrease from mid-2021 through the end of 2024. The probability line for an increase starts around 27% in 2021 before mildly dipping in 2022, then rises to 38% by May 2023 before gradually falling thereafter. The probability line for a rate hold starts around 53% and falls steeply to 34% by May 2023. It starts a gradual rise through November 2023 before falling again. The probability line for a rate decrease starts at 20%, then rises to 34% by August 2022, then slowly falls to 29% by May 2023, and keeps falling to 25% by November 2023. It then starts sharply rising, eventually going higher than the other two probability lines by June 2024. A vertical line overlaying both charts shows that this is roughly in sync with when Vanguard expects rate cuts.

Notes: The probabilities of the Fed’s next move being a rate increase, pause/hold, or decrease are generated by Vanguard's proprietary machine-learning model, factoring in macroeconomic and market data through May 2023. For periods beyond that, the model uses Vanguard’s in-house views on inflation (core CPI), labor markets, and economic growth this year and next as inputs to generate forward-looking probabilities of the Fed’s moves. Vanguard expects inflation to fall but remain above 3% by year-end, the unemployment rate to trend higher to 4.5%, and full-year growth to be around 0.75%.

Sources: Vanguard calculations using data from Bloomberg, Refinitiv Datastream, and Moody’s Analytics Data Buffet, as of May 31, 2023.

“Vanguard’s model uses 25 inputs in four broad categories—inflation, labor market, financial conditions, and global commodities—to produce probabilities for the direction of Fed moves in the near future,” said Boyu (Daniel) Wu, a Vanguard senior investment strategist.

The model incorporates data from the present, six months ago, and 12 months ago—all to simulate the type of decision-making made by the Federal Open Market Committee that looks at trends to set policy rates, Wu said. “Backtested over a five-year period, the model has been 80% accurate in predicting Fed moves and 77% more accurate than the traditional Taylor Rule, which uses inflation and GDP data.”

“The Vanguard model is unique in using both market and macroeconomic fundamentals as inputs,” Sathe said. “For Fed moves well into the future, where we don’t have current data as inputs, the model uses our economic team’s in-house views as inputs.”

As with any method of prognostication, there are no guarantees.

“If economic conditions become far worse than expected, the Fed may become dovish and start cutting rates sooner than expected, but we see that as unlikely,” Sathe said.

In the meantime, the model provides a more accurate assessment of probabilities, allowing active investors to potentially position themselves better and passive investors to have more conviction to stay the course.

Note:

  • All investing is subject to risk, including the possible loss of the money you invest.