Is the Fed’s Plan to Avoid a Recession Working?

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. The Federal Reserve has pivoted from their inflation fight with a big move. It has slashed interest rates by half a percentage point at the September meeting. The aggressive cut marks the first one since March 2020 as part of the pandemic response. But this time, balancing the risks of softening inflation and job market are motivating the Fed. What does this mean for Wall Street and Main Street? I sat down with Preston Caldwell to discuss that. He’s the senior US economist for Morningstar Research Services.

Thanks for joining me, Preston.

Preston Caldwell: Hey Ivanna, thanks for having me.

Morningstar’s Take on the Federal Reserve’s First Interest-Rate Cut in 2024

Hampton: Market watchers were divided over how much the Fed would cut. It wasn’t even a unanimous decision among the Fed governors, with one dissenting vote. What was your reaction?

Caldwell: Beyond the one dissenting vote, I’m sure there was lots of debate and contention ahead of this decision. Now, ultimately, they went with the larger cut of 50 basis points. We were surprised by this. I thought they would go with 25 basis points, just given their usual cautious and gradual mode of decision-making. But I think what tipped it for them is two things.

First, in terms of the data, we’ve seen much weaker data in terms of the labor market, mainly in terms of the unemployment rate ticking up, going up by half a percentage point in the last 12 months, taking a three-month moving average. So historically, that’s been a strong indicator that a recession will occur. So I think the Fed is watching that closely, and the inflation data has continued to be mild. The data indicates that the risks to both parts of the Fed’s dual mandate—high inflation, along with promoting full employment or lack of ability to get full employment—both of those parts, both of those risk components are about in balance right now. So there’s neither a pull from the data for the Fed to have extraordinarily high interest rates, nor extraordinarily low interest rates. So what that calls for is interest rates being about in line with their neutral levels. Given the large gap of current interest rates with respect to most people’s estimates of that neutral level, that calls for a relatively swifter cut in order to correct that divergence.

What Is the Neutral Rate of Interest?

Hampton: Preston, can you explain what the neutral rate is?

Caldwell: It’s one of these funny concepts because we can never exactly observe the neutral rate, but I think, as Powell said, we know it by its works. When interest rates are in line with their neutral levels, we should see the economy growing at a healthy rate, with the economy operating at its full capacity, full employment, but not overheating—inflation still running right in line with the Fed’s 2% target. This is kind of the interest rate that the Fed needs to target in order to hit that goldilocks zone where everything’s running exactly as it should be.

Now the thing is we can only estimate the neutral rate from the data very indirectly by looking at how it impacts inflation and GDP and labor markets and so on. So there’s lots of uncertainty exactly where it is, but economists generally, or Fed committee members think it’s in the range right now, but about 2% to 3% for the federal-funds rate versus the 5.25% to 5.50% rate that was prevailing prior to this last Fed meeting. So you can see there’s a gap of over 3 percentage points there, which is why if the Fed wanted to get much closer to that neutral rate, it wanted to cut more quickly by 50 basis points in this latest meeting.

Was the Half-Point Interest-Rate Cut ‘Timely’?

Hampton: Inflation has cooled and so has the job market. Fed Chair Jerome Powell called the half point cut “timely.” Can you talk about whether you agree or disagree?

Caldwell: Yeah, so Powell, he also said that we want to cut rates while the labor market is still strong. If we wait until it deteriorates too much, we will have waited too late. So I think that’s what he means there. And on the flip side, inflation is not all of the way back to 2%, particularly if you look at core inflation, it’s still at about 2.7% year over year, but it’s very close there. I would say the Fed believes that the main battle against inflation has been won, and really all that’s left is a mopping-up operation. And I do think that that’s correct. The Fed can act now instead of waiting for inflation to hit that 2% mark on every indicator and every time frame and so on. But in terms of anticipating further declines in the labor market, slowing in the labor market, and beating that to the chase, I think that’s what is key here, because once you get a significant major decline in the labor market, that can be a self-reinforcing process that can gain an unstoppable momentum that the Fed might be unable to prevent from plunging the economy into a recession. The Fed wants to act before that self-reinforcing process gains too much momentum, and so that’s what we’ve seen.

Risks That Could Cause Inflation to Reheat

Hampton: And a quick follow up, what risk, if any, could cause inflation to reheat?

Caldwell: Going back to talking about the neutral rate, what if the neutral rate isn’t 2% to 3% right now? What if it is, let’s say, 5%, but the Fed brings interest rates down to 3%? Well now all of a sudden we have monetary policy stimulating the economy. Concretely, we could see that in corporate investment, housing demand, and homebuilding: What if those parts of the economy heat up rapidly with the onset of lower rates and that stimulates economic growth, more spending, more hiring, and all of this fans the flames of inflation again? We wouldn’t see inflation go back to 6% like what the average was back in 2022, but we could see inflation in that scenario go back to 3% to 4%. And so that would create a lot more uncertainty for the economy. It’s definitely something to be worried about, but it’s far from our base case.

What Signs From the Job Market Could Spur the Fed Into Action?

Hampton: And unemployment ticked up this year and sits just above 4%. This is considered a healthy job market. What is the Fed watching for to determine if the situation is deteriorating and calls for immediate action?

Caldwell: The thing is that there are other parts of the job data that are not as alarming as the unemployment data. One thing to remember is that the unemployment rate comes from one survey, the survey of households, whereas we also have the nonfarm payrolls, which are watched by every economist. Those come from a separate survey of firms, and nonfarm payroll growth is still in strong positive territory in terms of growth, growing a little over 1% year over year as of the latest month. That’s a solid rate of growth. The best indication that we have that reconciles that with a rising unemployment rate is that unemployment is rising because of increased labor supply. Demand has pulled back a bit, but demand is not falling off a cliff, that is, we don’t see mass layoffs at this stage. We don’t see employers shedding their payrolls to a great degree. In fact, the layoff rate is still at a historical low.

We don’t really see the ingredients for this self-reinforcing process, where people are getting laid off, they cut their spending, that causes businesses to cut back further, cut back more jobs, unemployment goes up further, and you can see how this becomes a vicious cycle quickly. Right now, the ingredients of that process are not in place. And furthermore, just looking at the economy itself, we grew at about a 3% year-over-year pace in the second quarter, so independent of the job market, economic activity is still expanding solidly, which suggests that … it would be very surprising for the labor market to just leap off a cliff in that context because generally the labor market’s a lagging indicator, right? We see the economy slow down first and then the labor market follows with a lag. So all of this suggests that we shouldn’t be totally alarmed by the rise in the unemployment rate.

Does the Fed’s Forecast for Interest-Rate Cuts Line Up With Morningstar’s Expectations?

Hampton: Let’s talk about their quarterly projections for rate cuts. The Fed forecasts more cuts in November, December, and throughout 2025. How do their projections line up with Morningstar’s outlook?

Caldwell: Right now, really, we’re very close to what the Fed is projecting, based off the Fed’s latest projections issued yesterday, which are a significant reduction in the path that the federal-funds rate—in other words, more cuts expected than they had called for previously in their prior June projections. One thing I will note is they’re only calling for cuts of 25 basis points in the final two meetings of this year. So it’s not as if they’re expecting to cut by 50 basis points from here on out. But ultimately the Fed is expecting to bring the federal-funds rate down to 3.25% to 3.50% by the end of 2025, which is about in line with our expectations. We think it’ll be about 3.00%. It’s also close to what the market’s expecting. The market as of yesterday was expecting 2.75 to 3.00% for the year-end 2025 federal-funds rate.

So, we and the Fed and the market are all pretty closely aligned, at least for the very near term. And then I do think the Fed will continue to do a bit more cutting in 2026, ultimately bringing the federal-funds rate closer to 2.00% by the end of that year.

How the Housing Market Can Return to Affordability

Hampton: Now I want to focus the next part of our conversation on the everyday person’s wallet. Housing has been a sticking point. Higher interest rates rippled throughout the economy. What will it take for affordability to return, Preston?

Caldwell: As far as the national average 30-year mortgage rate, we’ve declined by well over 150 basis points compared to peak levels, which were almost as high as 8% at one point last year. Now we’re getting closer to 6% and continuing to decline. I mean, certainly, if the Fed continues to cut, the 30-year mortgage rate will fall further because it tends to correlate very closely with the 10-year Treasury yield, which already has dipped quite low, but it also has some sensitivity with respect to shorter-term interest rates like the federal-funds rates, so as that federal-funds rate falls further, we should see, I think, at least another 100-basis-points decline in the prevailing 30-year mortgage rate. I actually think it will ultimately get to an average of 4.75% by 2027, which is less than 100 basis points compared to what we averaged in the prepandemic years.

So getting quite a bit closer to that more-affordable housing, home-borrowing environment that we saw before the pandemic. Of course, housing prices are still quite elevated; that’s another ingredient to home affordability—up about 40% cumulatively since the start of 2019, so kind of well above their prepandemic trends. But I do think we’ll probably will see somewhat weak home price growth in the years ahead. So altogether, I think we’re going to converge to a much more affordable environment for homebuyers. And I wouldn’t necessarily go out and refinance right now, because I do think rates are going to head a little bit lower, so you might hold off on that.

What Lower Interest Rates Could Mean for Credit Card Borrowers

Hampton: Some hopeful news on that front. Consumer spending has mostly remained resilient. Retail sales rose slightly in August. If credit cards picked up the tab, what do lower rates mean for borrowers?

Caldwell: Yeah, borrowers love lower rates. The question is, what does that do for consumer spending? I would say, even with more-attractive borrowing terms, lower interest payments, I would suggest that households, they’re not going to go on a new spending spree from here because the household savings rate is already at a very low level, even as interest rates are high, which is, that’s a bit of a paradox. Normally we would say that high interest rates should be associated with savers or people increasing their savings to take advantage of those higher interest rates.

But in any case, it does look like maybe because asset prices are high, so there’s a big wealth effect and also you have the still lingering impact of those excess savings that were accumulated during the pandemic. That, because of those factors, the household savings rate is still running quite low. It’s actually about 400 basis points below 2019 levels, prepandemic levels. I do think that that’s main factor at play here—is that households will seek to increase those low savings rates. And so even with borrowing looking more attractive, I do think that consumer spending growth is going to remain fairly weak so that households can repair their savings rates a bit.

Is the Fed on Track to Avoid a Recession and Pull of a ‘Soft Landing’?

Hampton: And finally, with everything we discussed today, is the Fed on track to avoid a recession and pull off a so-called “soft landing,” and why did you think the way you do?

Caldwell: If we just look at the GDP data and the inflation data, we see the economy growing at 3% year over year and inflation clearly below 3%, getting very close to 2%. Everything about that says soft landing. But then on the other hand, the job is not 100% of the way done on inflation. And also, on the flip side, the labor market has this very concerning rise or somewhat concerning rise in the unemployment rate. So the data is not unambiguous here, but I would say overall, it strongly points toward a soft landing happening. That is our overwhelming base case.

But again, just going back to the beginning of the conversation, talking about the neutral rate of interest, I think achieving the soft landing is 100% possible right now, but it’s contingent on the Fed finding the correct neutral rate of interest and setting interest rates at that level because if it goes too high, then we could generate a recession. If we go too low, then we could have renewed inflation, which might entail more tightening, and that could create a recession. Really, it’s all about that neutral rate, and if the Fed can find it, then we will have a soft landing.

Hampton: Preston, thank you for your insights, your explanation about what the neutral rate is, and why we should follow that. Have a great day today.

Caldwell: Thanks, Ivanna.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen and Associate Multimedia Editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.