US President Trump and Treasury Secretary Bessent would very much like Fed Chair Powell to cut interest rates from the prevailing level of 4.5%. They would like to see cuts because at current borrowing rates for the US government, interest expense will continue to drive a wide budget deficit for years and adds to government debt, making it harder for Treasury Secretary Bessent to reach his stated goal of 3% deficits. However, the risk is that we do not see rate cuts anytime soon.
There are many policy rules that can be used to analyse or predict Fed policy. One useful rule is to take an estimate of the long-term neutral rate and add to it a cyclical variable which is half-weighted towards the degree of resource utilisation in the economy, and half-weighted towards the deviation of inflation from target. This rule explains and predicts the actual Fed funds rate quite well since the 1960s and incorporates most of the different factors that market commentators look at.
Historically, a reasonable proxy for the long-term neutral rate is 10-year annualised growth in aggregate hours worked plus 10-year annualised growth in the consumer price index (CPI). A reasonable proxy for resource utilisation in the economy is an average of excess labour demand (as defined by former Fed Governor Bullard), and industrial capacity utilisation. Based on these factors and noting that headline inflation is only slightly ahead of the Fed’s 2% target, we arrive at the conclusion that the Fed funds rate ought to be around 4%.
Figure 1: Fed funds rate and “Taylor rule” prescription
Source: Bloomberg, WAM
Fed bond portfolio considerations
Cursory examination of the relevant signals suggests that the Fed should cut rates further. But things are not this simple, because the Fed is losing money on its bond portfolio. By losses, we do not mean mark-to-market losses on the portfolio of bonds it accumulated since the quantitative easing (QE) days. Rather, we mean the interest income it pays to the banks on excess reserves net of the coupons it receives on its bond holdings. Currently, the Fed is losing around 0.2% of gross domestic product (GDP) via this channel. Historically, it earns 0.3% of GDP in net interest income. One could argue that the 0.5% of GDP difference is like a rate cut or two. After all, what profits that policy makers make come at the expense of the private sector. Therefore, the losses that they make must benefit the private sector, in this case, banks and depositors. In this way, one could argue that Fed losses explain the difference between current rates, and what policy rules suggest is appropriate. If the Fed cuts rates, it could make these losses disappear. However, there is now a degree of uncertainty about how policy transmits to the broader economy, let alone uncertainty about the drivers of interest rates. Importantly, this is not a new phenomenon, as investors and policy makers have been wrestling with the balance between savers and borrowers for years – indeed, ever since central banks started hiking rates post-pandemic, and post-QE.
Figure 2: Fed funds rate and Fed net interest income
Source: Bloomberg, WAM
Inflation uncertainty is high
On the topic of uncertainty about the drivers of policy rates, inflation is clearly front of mind. A composite leading indicator of CPI inflation assembles various measures of pricing power, costs, supply chain tightness and inflation expectations. It also takes into account house prices as a leading indicator of rents, and secondary market prices of used vehicle prices. Currently, this leading indicator points to 5% inflation. But various “now-casts”, such as the Truflation indicator, point to sub-2% inflation. Hawks argue that there is significant inflation in the pipeline from tariffs and supply chain disruptions. Doves argue that price pressures have either been absorbed by importers or cancelled out by weak demand. They also suggest that consumer survey evidence about inflation or stagflation are distorted. Suffice to say, there is incredible uncertainty about where inflation currently sits, and this uncertainty alone is a reason for the Fed to wait for more data.
Figure 3: US CPI inflation and leading indicator
Source: Bloomberg, WAM
Figure 4: US CPI inflation and Truflation gauge
Source: Bloomberg, Truflation, WAM
The key thing to note is that the Fed is constrained. Other central banks are not so constrained, and indeed, are inclined to cut rates. Further, we might expect longer-term bond yields to decline relative to short-term policy rates, reflecting the impact of tariffs and uncertainty on demand. The near-term complication however is that bond yields could rise first before they fall, because with the Fed likely to stay put with rates, volatility in the cycle and global trade/capital flows could show up in the long end of the curve, and longer-term bond yields could start to do some unintended adjustments of financial conditions for the Fed.
We favour quality exposures in equities
From an investment positioning perspective, near-term volatility in bond yields, and the longer-term prospect of curve flattening combined with the increased level of uncertainty caused by the potential implementation of tariffs, are reasons to favour quality exposures in equities.
