When Goldman Sachs came out with its forecast of the first US rate cut hitting in March, it sparked a fresh round of speculative excitement. While the US is the stronger economy compared to its European and UK counterparts and therefore will most likely be the first to cut, complications caused by the inflation environment make March an unlikely starting point, in our view.
Goldman’s forecast comes from analysis of the personal consumption expenditure (PCE) price index. PCE is the Federal Reserve’s preferred gauge of inflation. The six-month annualised number fell to 1.9% for December, in line with the 2% inflation target and facilitating the view that the battle against inflation has been won and rate cuts should follow imminently. Pre-emptive cuts in March, April and May ahead of the US election battle was the full forecast.
But a wrinkle in this analysis is suggested by the wider data landscape. While the long-term trend is towards a slowing US economy, monthly numbers show surprising resilience. January’s jobless claims registered their lowest reading since September 2022, and retail sales beat expectations for December, refusing to decline in the manner expected for a softening economy. Instead, the reasonably tight labour market means consumer activity remains robust.
With employment and inflation being backwards-looking indicators, we would expect to see this robustness begin to deteriorate over the next few months. But with the data we have today and GDP still tracking around 2%, these indicators signal that the US is OK for now and we’re unlikely to see a first cut until early summer.
This leaves us in the unexpected scenario where, despite the US being the notably stronger economy, it looks likely that the first Fed, European Central Bank (ECB) and Bank of England (BoE) rate cuts will occur within a few months of each other.
The complexity comes due to the fact that each central bank is cutting for different reasons. Recession risk is real in Europe and the UK, which limits the “higher for longer” mantra, while the US faces the potential risk of overshooting the inflation target to the downside, and/or creating a recessionary environment by holding rates too high for too long. A nuance, but an important one.
Out of the three economies, inflation is highest in the UK today, but it’s tracking down and this trend is expected to continue through to the summer months, driven by falling energy prices. Food inflation has already tapered off significantly, so with energy cuts added to the mix, we’re likely to see inflation fall into the 3% range as we hit the summer, and that should be enough for the BoE to begin cutting.
In terms of the market view, the probability of a first US cut in March has fallen from nearly 85% at the end of 2023 to around 50%, fuelled by data and the rhetoric coming out of all three central banks tempering expectations regarding the speed of cuts – they have been clear to communicate that they will cut, but they’re not in a rush.
So, although we understand Goldman’s view based on PCE, we don’t see it as a strong enough standalone factor to trigger early cuts against a background of robust US data and steady Fed messaging. Our view is that the US will begin a trend of rate cuts in early summer, with the ECB following shortly behind and the BoE bringing up the rear. While the ECB and BoE have the sole mandate of inflation, versus the Fed’s dual mandate of price stability and maximum employment, we believe summer cuts will come even if inflation doesn’t get right down to 2%, as the negative effects of being too tight for too long begin to loom large.
