Fed Teases 2024 Rate Cuts

Here are some of the biggest stories from last week:

• China's economy continued to experience deflation during November.
• Real borrowing costs in China are at their highest level since 2016.
• US inflation matched expectations across the board last month.
• UK wage growth slowed sharply in the three months to October.
• The UK economy unexpectedly shrank in October.
• The Fed, BoE, and ECB all held interest rates steady.

Dig deeper into these stories in this week’s review.

China

China's economy continued to experience deflation last month, highlighting the country’s struggle to shore up growth by boosting domestic demand. Consumer prices fell by 0.5% in November from a year ago – the steepest decline in three years and far worse than the 0.2% drop forecast by economists. It also marked the second consecutive month of deflation, undermining a recent assessment by the Chinese central bank that prices would rebound from the summer’s rough patch. What’s more, producer prices, which reflect what factories charge wholesalers for products, fell for a 14th straight month, dropping by a bigger-than-expected 3% in November.

China has struggled with falling prices for much of this year, in stark contrast with many other regions where central banks are primarily concerned with controlling inflation instead. Prolonged deflation is a big risk for China because it can lead to a downward spiral of economic activity: anticipating further price drops, consumers might delay purchases, further dampening already weak consumption. Businesses, in turn, might lower production and investment due to the uncertain demand outlook.

Deflation is also causing real borrowing costs to surge. In fact, these rates, which are adjusted for inflation and reflect the true cost of borrowing funds, have topped 4% and may even be near 5%, which would be the highest level since 2016. That’s because consumer and producer prices have fallen at a much faster pace than the country’s average loan rate (a figure mainly based on changes in benchmark rates set by the Chinese central bank and major lenders). And with deflation pressures expected to linger, real borrowing costs are expected to stay high next year, posing yet another threat to growth in the world’s second-biggest economy. The situation is likely to amplify demands for much-needed policy support, such as more interest rate cuts or a further reduction to banks’ reserve requirement ratios.

UK

Wage growth in the UK slowed at the sharpest pace in almost two years, providing further evidence that the labor market is cooling in response to a flagging economy. Average annual growth in regular earnings, excluding bonuses, was 7.3% in the three months to October, down from 7.8% in the period through September. Economists had expected a figure of 7.4%. Annual growth in total pay, meanwhile, slowed to 7.2% after hitting a record high of 8.5% in July. What’s more, the unemployment rate held steady at 4.2%. All in all, the figures will strengthen arguments that the Bank of England might have sufficiently addressed inflationary pressures originating from the labor market, after delivering the most aggressive series of rate hikes since the 1980s.

While these aggressive rate hikes are effectively combating inflationary pressures, they’re also having a substantial negative effect on the economy. Case in point: the UK economy unexpectedly contracted by 0.3% between September and October, after a 0.2% expansion the previous month. The drop was the first since July, with all three main sectors – services, production, and construction – reporting a fall. The data marks a disappointing start to the final quarter after the economy stagnated in the three months to September, suggesting elevated inflation and high borrowing costs continue to weigh on growth. In October, the economy was no bigger than at the start of the year and smaller than last spring. Adding insult to injury, the BoE expects almost no growth at all next year.

Speaking of the BoE, the central bank kept interest rates unchanged at a 15-year high of 5.25% this week, sticking to its message that borrowing costs will remain elevated for some time despite growing bets on a wave of cuts in 2024. That makes sense given that the current inflation rate in the UK is still more than double the BoE’s 2% target, with policymakers warning of another potential hike should inflationary pressures persist. In fact, this week’s interest rate decision saw three out of the nine members of the BoE's Monetary Policy Committee vote in favor of a quarter-point hike. Lastly, in updated forecasts, the central bank now expects the British economy to be flat in the fourth quarter after shrinking in October – a downward revision from the 0.1% growth expected in its November meeting.

US

Over in the US, inflation cooled in November as anticipated on an annual basis, but unexpectedly accelerated on a month-over-month basis. Consumer prices rose by 3.1% from a year ago – in line with forecasts and a small tick lower from October’s 3.2% pace. Core inflation, which strips out volatile food and energy prices to give a better idea of underlying price pressures, matched forecasts to remain flat at 4% in November. On a month-over-month basis, headline inflation came in at 0.1%, defying economist expectations to remain unchanged from October’s 0% pace. Core inflation accelerated to 0.3%, in line with forecasts. The uptick in both measures suggests that price pressures remain stubborn, and that the fight against inflation isn’t over yet.

Acknowledging the reduction in inflation but emphasizing that the battle hasn’t been won yet, the Fed kept interest rates unchanged for a third meeting in a row and gave its clearest signal yet that its aggressive hiking campaign is over. The benchmark federal funds rate was held steady at a 22-year high of 5.25% to 5.5%, with the decision coming alongside new forecasts pointing to 75 basis points worth of cuts next year – a more dovish outlook for interest rates than in previous projections. The central bank’s “dot plot” showed most officials expected rates to end next year at 4.5% to 4.75% and 2025 at 3.5% and 3.75%. Those dovish projections triggered a big rally in US stocks and a sharp fall in Treasury yields, with the two-year yield recording its biggest daily decline since the collapse of Silicon Valley Bank in March.

EU

Joining the rate-pause party was the European Central Bank, which left its key deposit rate unchanged at an all-time high of 4%. It joined the BoE in pushing back against market expectations for it to cut rates early next year, signaling that it still has work to do to tame price pressures even as it cut its inflation forecasts for this year and 2024. The ECB now expects headline inflation to average 5.4% in 2023, 2.7% in 2024, 2.1% in 2025, and 1.9% in 2026. Reflecting the bloc’s weaker outlook, the central bank also trimmed its growth forecasts for this year from 0.7% to 0.6%, and for next year from 1% to 0.8%. It left its 2025 growth forecast at 1.5% and predicted a similar outcome for 2026.

Finally, the ECB also announced an adjustment to its ongoing bond-buying program, saying it will scale back the reinvestments of maturing securities within its €1.7 trillion portfolio, which it started buying in response to the pandemic, from the second half of next year instead of continuing them until the end of 2024. The reinvestments would be cut by €7.5 billion a month from July before ending them completely at the end of next year.

Next week

• Monday: German business climate index (December), US housing market index (December).
• Tuesday: Bank of Japan interest rate announcement, China one-year loan prime rate announcement, US housing starts (November). Earnings: FedEx, Accenture.
• Wednesday: Japan trade balance (November), UK inflation (November), US existing home sales (November), US and eurozone consumer confidence (December). Earnings: Micron Technology.
• Thursday: Earnings: Nike.
• Friday: Japan inflation (November), UK retail sales (November), US new home sales (November), US durable goods orders (November).