The Federal Reserve Begins Rate Cut Cycle with 50-bps Reduction

The Federal Reserve has officially initiated its rate cut cycle, starting with a 50-basis point (bps) reduction, bringing the federal funds rate down to 4.75-5%. Prior to this announcement, markets were expecting a more aggressive reduction, with a projected 125 bps cut in 2024 and an additional 100 bps in 2025. However, the Fed's updated dot plot reveals a slightly more hawkish outlook, indicating another 50-bps cut by the end of 2024 and a further 100-bps cut in 2025.

Risk-On Sentiment and US Economy Outlook

Much of the market's risk-on sentiment in the upcoming months will depend on whether the US economy can achieve a soft landing, as well as the extent of policy divergence between the Federal Reserve and the Bank of Japan (BOJ). Historically, a Fed rate cut tends to cause an initial drop in US equity markets, with recovery typically occurring after the interest rate cycle has bottomed out.

Fed Dot Plot and Policy Stance

The Fed's dot plot now forecasts another 50-bps rate cut in 2024, likely divided into 25 bps cuts at each of the next two meetings, with an additional 100-bps cut expected in 2025. However, the Fed's governor emphasized that 50-bps rate cuts may not become the norm, with the Federal Open Market Committee (FOMC) taking a more cautious, meeting-by-meeting approach going forward.

In its statement, the FOMC focused on inflation's gradual progress toward the 2% target, while acknowledging that inflation remains elevated. The committee noted that risks to achieving its employment and inflation goals are "roughly in balance." Notably, one governor, Michelle Bowman, dissented from the majority, opposing the 25-bps cut. During the press conference, the Fed reiterated that it would continue to be data-dependent in its policy decisions.

Inflation, Labor Market, and Recession Concerns

The Fed's updated projections indicate that inflation will gradually approach the 2% target, with estimates for PCE inflation in 2025 being revised down to 2.1%, 20 bps lower than in the June policy meeting. Additionally, while the labor market is weakening, there are no clear signs of an impending recession or financial crisis. Nonetheless, markets will scrutinize every economic data point to gauge the size and timing of future policy adjustments, leading to increased volatility.

Market Shifts Toward BOJ Policy

With the Fed embarking on its rate-cutting cycle, market attention is likely to shift toward the BOJ. Any potential rate hikes by the BOJ, or even the anticipation of such moves, could accelerate the unwinding of carry trades, especially as the Japanese yen strengthens against the US dollar. Large foreign exchange (FX) moves could trigger risk-off sentiment, impacting other asset classes. Although fears of significant quantitative tightening have eased and global money supply is stabilizing, monetary policy divergence between central banks will remain a key concern for emerging markets, including India.

Our View

1. US Economic Outlook: We anticipate that the US economy will disinflate without entering a full-blown recession. The Fed is likely to implement two 25-bps rate cuts in upcoming meetings, though larger cuts may be considered if:

   • Disinflation accelerates faster than expected.
   • Labor market data weakens more than anticipated.

2. RBI Policy: The Reserve Bank of India (RBI) is expected to remain focused on domestic dynamics. With stable domestic inflation and favorable global conditions, the RBI could shift to a neutral policy stance in October, particularly as liquidity remains comfortable. We maintain our forecast for a rate-cut cycle of 75-100 bps beginning in December, as inflation trends toward 4% by FY2026.