The Fed’s Contemplating More Rate Hikes. Investors Are Soon Expecting…Cuts. Here’s What Gives.

The Federal Reserve’s (the Fed) rate-hiking campaign finally seems to be having an impact on oh-so-stubborn inflation. It might sound counterintuitive, then, that investors are now eyeing up the potential of rate cuts. Let’s unpack the reasons why the central bank would want to hit reverse just as it’s seeing the fruits of its labor, and assess what would happen to the economy and different asset classes if it does.

Why would the Fed cut rates?

The Fed's got a two-fold mission: keep inflation around 2% and keep as many jobs filled as possible. Sounds straightforward, sure, but it's a balancing act akin to juggling on a unicycle. See, amping up the economy to create jobs can lead to increased demand for goods and services, potentially causing prices to rise. And vice versa, cooling the economy to control inflation might put business growth on ice, increasing unemployment. So that’s the challenge: maintaining one half of the job without unintentionally exacerbating the other.

Let’s apply that to where we are now. The Fed went full throttle during the pandemic, slashing rates to historic lows. That helped create inflation, which the central bank’s been fighting with aggressive interest rate hikes ever since. Finally, there are signs that those hikes are starting to put a damper on inflation – and what’s more, the economy’s holding up at the same time. But even though those hikes seem to be working their magic, Wall Street’s whispering of potential rate cuts. So here’s what gives.

The Fed might want to cut rates for two reasons:

The economy will eventually slow, and the Fed will have to bolster it.

Historically, the Fed’s feistiest hikes have almost always pushed the economy into a recession. That’s because the Fed’s inflation-fighting tools aren’t laser-focused and their results come with long and variable lags. Essentially, the central bank’s stuck threading a needle in the dark. Then when a recession does hit, the Fed dials down the rates to give the economy a leg up and protect jobs. So if investors expect a recession, they’ll also expect the Fed to slash rates.

Lower inflation will give the Fed a chance to normalize its monetary policy.

Rate cuts aren’t just used when the economy takes a turn for the worse. If inflation cozies up to its target, it gives the Fed the chance to reset its monetary stance – even if the economy's doing well as a whole. Remember, one of the Fed’s jobs is to keep employment in check. So once inflation’s in line, it can steer rates back in a bid to buoy up job numbers. Plus, if for some reason the Fed didn’t pull rates down as inflation cools, the real borrowing cost – that’s the interest rate minus inflation – would nudge up. In other words, the Fed would actually be tightening the purse strings.

So when will the Fed start cutting?

The Fed's keeping rate cuts off the table for now, but check out the chart below. The green line shows an estimate of where Fed members think interest rates are headed, and the chart hints at a dip of about a percentage point by the end of next year. That means rate reductions are likely on next year's agenda.

FOMC median dot-plot (green) versus market expectations (white). Source: Bloomberg

Investors are more daring. They predict the Fed’ll make its move as early as the first quarter of next year (orange bars turning negative), and think that's likely to follow one more modest rate hike in the coming months.

Investors’ expectations of rate hikes and cuts. Source: Bloomberg

That’s pretty consistent with previous cycles. As you can see in the chart below, the Fed's typical playbook shows rate cuts happening a few months (roughly five, but often sooner) after wrapping up its rate hikes.

Months before the first cut. Source: Nordea

Personally, I think investors will be waiting for that initial rate drop a little longer than they anticipate. The Fed’s moving carefully to avoid an inflation encore. So most likely, it’ll only make its move when inflation’s truly tamed – and that might test the market's patience. Plus, if the central bank does manage to get inflation in check, firm up the economy, and promote a healthy job market, rate cuts could seem like a roll of the dice at a time when stability’s finally been achieved.

How fast will the Fed cut?

The Fed's tempo will hinge on the beat of growth and inflation in the coming months. If inflation cools off at investors’ predicted pace, the Fed's likely to take the scenic route, trimming rates in neat 0.25 percentage-point chunks every quarter. But toss in a few hiccups, and it might hit the gas with back-to-back 25 percentage-point snips, reminiscent of 2019's rhythm. If those growth jitters morph into full-blown alarm bells, expect a more dramatic cut – think 2008 vibes.

As for investors, they're currently picturing a single percentage-point dip one year after the final hike. That’s not impossible, but it’s tame. Historically, central banks have often slashed rates by over 1% in the year after rate hikes end. And as you can see in the chart, it can be much more than that.

Historical distribution of cuts within the first year of cutting. Source: Goldman Sachs

What’s the opportunity?

Investors are currently placing their chips on the soft-landing board. In other words, they’re hoping inflation saunters back to its target without dragging the economy into a recession. This, teamed with falling interest rates as the Fed normalizes its monetary policy, could spell sunshine for nearly all asset classes – particularly for stocks. Thing is, today’s prices already carry this narrative, so any plot twists could give the market a jolt.

Let’s see how that could play out:

Inflation stays stubborn: Inflation might not drop as swiftly as the market’s hoping for, especially if tricky obstacles crop up. Watch out for unyielding energy prices, shelter inflation – think rent and utilities – that seems to be hitting a plateau, and tenacious service inflation. Add a recovering economy to the mix, and inflation may don its hiking boots again. For the Fed, that could mean keeping rates higher for longer, possibly even into next year (red line). Paradoxically, a vibrant economy today could set the stage for a potential stumble tomorrow. That’s because the more the Fed tightens the reins now, the trickier it becomes to predict the ripple effects – and history hasn't been kind in times like this. In this inflationary scenario, stocks and bonds might face headwinds. Commodities, though, could prove their resilience.

Scenarios of potential rate paths. Source: Goldman Sachs

A recession rears its ugly head: The jury’s still out on whether a full-blown recession will take hold, and the economy has been known to toss a curveball our way. If it does take a nosedive, inflation could fall enough to let the Fed start a rate-cutting spree (grey line). That scenario wouldn’t be great for stocks, with weak earnings and pessimistic outlooks overshadowing the benefits of lower rates. Even commodities could wobble as global demand shrinks. But hope’s not lost: bonds and gold could save the day, benefiting from tumbling rates and offering investors a taste of stability.

If you’re on the fence about the economy's next big move, casting a wider net across diverse asset classes might be a smart play. So is holding onto some cash: it's like keeping an ace up your sleeve, so you’re ready to dive into markets when there’s potential to build a killer hand.