By Hilary Schmidt, International Banker
On November 14, the U.S. Bureau of Labor Statistics (BLS) reported that the annual inflation rate in the United States had fallen to 3.2 percent in October from 3.7 percent a month earlier. This figure was also lower than what analysts had broadly expected and had significant impacts across many financial markets, with traders growing increasingly confident that the Federal Reserve (the Fed) had finished its rate-hike cycle and the CME Group’s FedWatch Tool recording a 20-percent jump in expectations of a rate cut at the Fed’s March 2024 meeting. But with considerable debate over whether rates will be dramatically cut in 2024 or remain at broadly elevated levels throughout the year, how much longer will the pain from the Fed’s higher-for-longer regime be felt?
Since March 2022, the Federal Reserve has aggressively raised its benchmark federal funds rate from near-zero to where it currently stands in the 5.25-percent-to-5.5-percent range. Other leading central banks, including the European Central Bank (ECB) and the Bank of England (BoE), have closely followed suit as policymakers worldwide have become increasingly desperate to claw back inflation, which by the summer of 2022 had, in several cases, hit double figures. And with annual prices comfortably above official target levels in most major jurisdictions, central banks’ officials, led by the Fed’s Board of Governors, have been proclaiming the need for rates to remain “higher for longer” to continue easing price pressures.
The fallout from such a strategy was most visible in October, when an unprecedented bond market collapse sent US long-dated yields to 16-year highs, extending what was already the worst bear market on record for the asset class. Stock markets have also failed to escape the gloom, with the S&P 500 (Standard & Poor’s 500) shedding more than 4 percent of its value during the last two weeks of October.
The 2023 US economy has been decidedly painful for borrowers, whereby companies and households have had to either take out loans at excruciatingly high rates or delay their plans until rates eventually fall and borrowing becomes more affordable. Many borrowers who previously took out loans are also exposed to this sharply rising-rate environment and will continue to struggle to fulfil their repayment obligations or have to refinance their existing facilities at much higher costs.
“For sure, we’re going to see rates higher for longer,” Greg Guyett, chief executive officer of HSBC’s Global Banking and Markets unit, told CNBC on October 17, adding that continued high borrowing costs were creating a “very quiet deal environment” with weak capital issuances and recent public listings struggling to find bidders. “I will say that the strategic dialog has picked up quite actively because I think companies are looking for growth, and they see synergies as a way to get that, but I think it will be a while before people start pulling the trigger, given financing costs.”
According to August estimates from Goldman Sachs, moreover, a whopping $1.8 trillion of corporate debt will mature over the next two years—$790 billion of which will mature in 2024, followed by another $1.07 trillion in 2025. The US bank also noted that the average interest rate on corporate debt will likely rise to 4.5 percent by 2025 from the August 2023 rate of 4.3 percent, which will weigh on companies’ revenues and, ultimately, US economic growth. “If interest rates remain high, companies will need to devote a greater share of their revenue to cover higher interest expense[s] as they refinance their debt at higher rates,” said Goldman Sachs’ chief economist, Jan Hatzius. “We find that for each additional dollar of interest expense, firms lower their capital expenditures by 10 cents and labor costs by 20 cents.”
Advanced economies have not been the only ones hurt by high interest rates this year. With developing economies already burdened by mounting debt piles from the pandemic, higher US interest rates have further compounded their miseries to create a “silent debt crisis”, according to the World Bank, which recently found that emerging and developing countries with borrowing costs more than 10 percentage points greater than the US’ have exploded in number from 5 percent in 2019 to 23 percent this year. Speaking to the Financial Times (FT) on November 6, the World Bank’s deputy chief economist, M. Ayhan Kose, acknowledged that the monetary-policy tightening cycle had been a “nightmare” for lower-income countries with high debt levels. “Given the well-defined challenges these economies are facing with respect to rolling over debt obligations…we are saying there is a silent debt crisis that has been taking place.”
But with the Federal Reserve deciding in November to keep rates within the 22-year-high 5.25-percent-to-5.5-percent range for two straight meetings and the October inflation figure coming in lower than anticipated, beliefs that further Fed hikes will not materialise are growing. That said, that does not mean that rates will necessarily be cut anytime soon. “Another way of saying higher for longer is ‘not zero’,” Torsten Sløk, chief economist at Apollo Global Management, told the Financial Times. “We’re not going back to zero.”
Indeed, a Reuters poll of economists published on November 9—prior to the announcement of the surprise October inflation figure—predicted that the Fed would hold its federal funds rate steady throughout most of the first half of next year and that the first cut would transpire later than was expected during the previous month’s poll. Eighty-seven of the hundred economists polled from November 3 to 9 said the Federal Open Market Committee (FOMC) was finished with its aggressive rate-tightening cycle. That compares with 26 of 111 in an October survey. And although 86 percent of economists did not envisage a rate cut during the first quarter, a 58-percent majority expected a cut by mid-year. “In our base case, the Fed is done hiking, inflation will remain above target, and rates will remain elevated across the curve,” said Andrew Hollenhorst, chief US economist at Citibank. “The plan now is to be ‘careful’—a word used multiple times in the press conference—in further rate increases.”
Nonetheless, some insist a rate cut will happen as early as the first quarter. “We expect economic growth to slow sharply in the next few quarters, with a mild contraction worth half a percentage point in the middle of the year,” UBS stated in a November 13 note, adding that it expected gross domestic product (GDP) for the year to grow by just 0.3 percent, much slower than the 3-percent gain over the previous four quarters. UBS observed that it expects the Fed will have begun to nudge rates lower by March, with 275 basis points of cuts throughout the year, leaving the federal funds rate at 2.50-2.75 percent by the end of 2024. “However, as the slowdown in the economy and the extra disinflationary leg begin in earnest, we expect the Fed in the second half of the year to turn to full-on accommodation, with more rate reductions, in line with what it has done historically.”
UBS also predicted the unemployment rate would rise by more than a percentage point, reaching 5 percent by the end of 2024. And with the jobless rate already ticking upwards from 3.5 percent in July to 3.9 percent by October, this could put further pressure on the Fed to ease rates next year and avoid a recession. According to Royal Bank of Canada’s (RBC’s) senior economist, Claire Fan, even though “softer conditions are showing up more significantly” in payroll data, momentum in hiring activity remains. “But clearer signs of moderating wage growth and low inflation readings mean the Fed should not need to hike again in the current cycle while waiting for softening economic conditions to emerge elsewhere,” Fan noted.
Ultimately, the equation remains straightforward for central banks; rates will remain elevated until policymakers are convinced that inflation is heading towards formal monetary-policy targets. But with the November 9 Reuters poll also finding that all inflation measures—the Consumer Price Index (CPI), core CPI, personal consumption expenditures (PCE) and core PCE—were predicted to remain above the Fed’s 2-percent target until at least 2025, higher-for-longer may not be over yet.