Former "Three Musketeers" of the Federal Reserve: The Fed will eventually cut interest rates, but later than market expectations, focusing on these two key indicators

As we are more than halfway through the year, the prospect of a rate cut by the Federal Reserve still faces uncertainty.

On June 28th, Bank of America Merrill Lynch released a research report summarizing the speech by William Dudley, former president and CEO of the Federal Reserve Bank of New York, at the 2024 Boao Forum for Asia. During the meeting, Dudley analyzed key economic indicators such as the expected economic growth of the United States, unemployment rate, and service sector inflation, and discussed the outlook for a rate cut by the Federal Reserve.

Overall, Dudley believes that the US economic growth will gradually slow down, the Federal Reserve will cut rates, but the timing and pace of the rate cut will be later than market expectations, with the yield on the 10-year US Treasury expected to be at 4.5%.

Interest Rates Expected to Remain High for Longer, Neutral Rate Level May Rise

Dudley believes that the US economy is showing a mixed trend overall.

He stated at the meeting that the lower-than-expected GDP in the first quarter was mainly due to drag from exports and seasonal factors. He expects GDP growth in the second quarter to rebound to the range of 2%-3%, with wages showing strong growth momentum. However, on the other hand, weak retail sales data and household employment surveys are causing concerns for economic growth.

Furthermore, Dudley pointed out that inflation remains stubborn due to better-than-expected economic performance. The key to overcoming inflation lies in the service sector, driven by labor shortages and wage-driven high prices.

Therefore, Dudley indicated that if both weak economic growth and inflation falling to the target occur, the Federal Reserve will start cutting rates. However, since neither of these scenarios has happened yet, this means that the current monetary policy may not be as tight as perceived, leading him to lean towards the camp of interest rates being "higher for longer".

Dudley supports the market's expectation of the neutral rate level for the Federal Reserve until 2026-2027 to be at 3.6%, which is higher than the Federal Reserve's own expectation of 2.8%. There are two specific reasons for this:

1. In the coming years, the inflation rate will not fall to 2%, and the 2% inflation target is actually "asymmetric" because the Federal Reserve is more inclined to avoid deflation rather than benign inflation;

2. The neutral rate level will rise due to the long-term massive fiscal deficits in the United States and the upcoming retirement of the "baby boomer" generation, which will suppress savings and further raise the neutral rate level.

Focus on Two Indicators: Unemployment Rate and Core Service Inflation Excluding Housing

Looking ahead, Dudley believes it is necessary to focus on two indicators: the unemployment rate and core service sector inflation excluding housing.

Historically, whenever the unemployment rate rises by more than 0.5 percentage points on a 3-month moving average basis, the US economy always enters a recession.

The main driver of service sector inflation comes from wages. Powell has hinted that a wage inflation rate of 3%-3.5% may be consistent with a 2% inflation rate, while the current wage inflation rate is slightly above 4%.

Additionally, Dudley mentioned several risk factors, including elections, fiscal trajectory, and financial stability.

Specifically, in Dudley's view, Trump's presidency is more likely to trigger upward inflation risks, as his policies during his tenure are highly uncertain and may interfere with the Federal Reserve's independence in formulating monetary policy In terms of finance, Dudly believes that the Congressional Budget Office (CBO) in the United States is still too optimistic about the estimated cumulative deficit of 22.1 billion US dollars over the next 10 years, despite a 10% deterioration from four months ago. This may put pressure on interest rate cut expectations. In addition, Dudly believes that other financial risks are not significant