The only question on investors’ minds today is how soon the Fed will begin cutting interest rates and by how much.
After a strong jobs report, a slight increase in manufacturing activity, and surprisingly high inflation in January, March is no longer in view, and the markets favour May or June for the first cut.

Monetary policymakers are concerned about sustaining growth: with inflation at more reasonable levels and expectations of further price increases under control, they may give more weight to the “full employment” part of their mandate. However, if the economy remains strong and the labour market is tight, they may keep rates high for a little longer to ensure a sustainable inflation return below 2%. Markets also play a role: as long as they expect rate cuts, easier financial conditions will support growth, although this, of course, has limits, as demonstrated by the turbulence surrounding the last inflation report.

The Fed must also address deeper structural issues. Firstly, why is the economy so strong? Perhaps previous monetary tightening has not yet entirely borne fruit, or reducing frictions in supply chains and the labour market has given a transient boost to growth. Fed Chair Jerome Powell has suggested that both are true. If so, the economy will soon slow enough to tilt the balance in favour of rate cuts.

However, I favour another explanation: monetary policy may not be so tight. In other words, the neutral interest rate adjusted for inflation, the level that neither stimulates nor restrains growth, is higher than the Fed officials’ estimate. This would mean that the current federal funds rate is less restrictive for growth. The argument finds justification in significant budget deficits and public investments for a decarbonized economy. Added to this is the end of Globalization, which was a deflationary phenomenon. The rise of protectionism and the emergence of regionalization in the global economy adds further weight to this explanation. These factors, some of which are structural, have pushed up the neutral interest rate. If this is the case, the Fed should keep rates higher for longer, even raise them to seek the neutral rate for the economy.

With so much uncertainty in a rapidly changing technological world and a highly complicated international context, investors’ optimistic convictions look like a dream. Developments in the situation may lead the Fed to maintain high rates well beyond June, even to raise them, a scenario not currently envisaged by investors. The awakening could prove painful.