Traders beware: December Fed rate cut is no slam dunk

Many traders and investors expect the Federal Reserve to cut interest rates again at its meeting in December, but they may be jumping the gun. 

With the economy humming along, the Fed may leave rates where they are for now. “We are not on any preset course. We will continue to make our decisions meeting by meeting,” Fed Chair Jerome Powell said after the central bank lowered rates last week.

As for the economy, “it is strong overall and has made significant progress toward our goals over the past two years,” he noted

GDP grew 2.8% annualized in the third quarter, following a 3% expansion in the second quarter. And the Atlanta Fed’s forecast model puts growth at 2.5% for the fourth quarter.

So if the economy is so solid, why did the Fed lower rates this month? In a word, it’s insurance – insurance against a potential weakening of the economy. 

The Fed directs interest rates with its target for the federal funds rate. That’s the rate which banks charge each other for overnight loans. Banks lend to each other to maintain stable reserves.

The central bank’s fed funds target is now 4.50% to 4.75%, down 75 basis points from when the Fed began reducing rates in September.

A neutral interest rate

Long-term, the Fed shoots for a “neutral” fed funds rate, which central bank officials currently peg at 2.5% to 3.5%. The neutral rate is where the Fed is neither restraining economic growth nor boosting inflation.

A 2.5% to 3.5% fed funds rate is far below the current 4.5%-4.75% range of course. “Even with today’s cut, policy is still restrictive,” Powell said last week. “We understand it’s not possible to say precisely how restrictive, but we feel that it is still restrictive.”

This would indicate more rate decreases are coming. Interest-rate futures point to a 65% chance for a rate cut (25 basis points) in the Fed’s December meeting, according to CME FedWatch. But given Powell’s remarks, a 50% probability may be more accurate. 

Price increases are the issue. “Overall, inflation has moved much closer to our 2% longer-run goal, but core inflation remains somewhat elevated,” Powell said.

Inflation numbers

The Fed’s favored inflation indicator (the personal consumption expenditures price index) rose 2.1% in the 12 months through September. But core inflation, which excludes volatile food and energy prices, registered 2.7%. That could discourage the Fed from cutting rates again quickly. 

“If the economy remains strong and inflation is not sustainably moving toward 2% we can dial back policy restraint [i.e. cut rates] more slowly,” Powell said. 

The Fed has a delicate balancing act when it comes to cutting rates. “We’re trying to steer between the risk of moving too quickly and perhaps undermining our progress on inflation or moving too slowly and allowing the labor market to weaken too much,” Powell said.

The 2.1% September inflation rate is down from 2.7% last December. And unemployment has risen to 4.1% in October from 3.7% last December.

So it appears that the Fed will continue trimming rates to insure that the economy doesn’t stumble. But it may be a slower process than investors expect.