CONTRIBUTION Why rate cuts are to come later this year

A greater confidence in a disinflationary trend, specifically driven by services, is necessary for the U.S. Federal Reserve to begin its rate cut cycle. It is anticipated that both the Fed and the Bank of Korea (BOK) will likely commence rate cuts in July.

In October of last year, the 10-year Treasury yield in the U.S. experienced a significant surge, reaching as high as 5 percent. This surge was attributed to uncertainties surrounding monetary policy and apprehensions regarding increased treasury issuances aimed at funding the government deficit. The Fed left its policy rate unchanged at 5.25-5.50 percent in September, but penciled in another rate hike in its dot-plots to address the upside risk of inflation. The U.S. Department of the Treasury announced that it would issue as much as $1.1 trillion in bonds in the third quarter last year, which was a historical high among third-quarter issuances.

Roller-coaster ride of U.S. long-term yields

Those uncertainties and concerns have eased swiftly as both the Fed and the Treasury Department changed their stances. In the following Federal Open Market Committee (FOMC) meetings in November, Fed Chair Jerome Powell commented that the validity of September rate forecasts decreased.

In December, the committee turned even more dovish. Dot-plots for an appropriate policy path indicated that the rate hike cycle finally came to an end, and the chair said that rate cut discussions had begun. The Treasury Department came up with a much smaller issuance plan for the fourth quarter of 2023 ($776 billion) and first quarter of 2024 ($760 billion).

As those forces prompting a surge in yields reversed, market yields experienced a significant and dramatic decline. The 10-year U.S. treasury yield fell below 4 percent by the end of 2023, pricing in a rate cut as early as March 2024. Now, such expectations have once again reversed to some degree.

Federal Reserve opts to cut later than sooner

Despite such a roller-coaster ride in yields and Fed policy expectations during recent months, our brokerage, since last October, has been maintaining a view that the Fed is most likely to cut its policy rate by July this year.

We do agree that there has been a lot of progress in terms of disinflation. The core personal consumption expenditure (PCE) inflation rate stood at 2.9 percent as of December last year, after peaking out at 5.5 percent in September 2022. Core consumer price index (CPI) growth is below 4 percent in January, and excluding shelter from the core, the number stands at a mere 2.2 percent, very close to the Fed’s inflation target.

That said, whether such a trend can be sustainable raises some questions. Currently, disinflation in the U.S. is driven mainly by goods and partly by housing. Global supply chain pressures have eased significantly over the past quarters, as well as observed rent price growth already subsiding. The latter will affect relevant components in CPI and PCE price growth to slow ahead.

To make this disinflation more sustainable, non-housing services inflation should slow further and play a key role in sustaining the trend. Unlike other components, inflation for non-housing services is affected by wage growth. This is because most of the services that we consume are labor-intensive. Food services and private care services can be good examples. This means that higher labor cost burdens can easily translate into rising service fees, as service providers will be trying to pass on the cost burdens to consumers.

Wage growth is still elevated in the U.S. Average hourly earnings have risen 4.5 percent over the year until January, and Atlanta Fed’s Wage Growth Tracker — an index based on a panel survey — stood at 5 percent. We can compare this with 3.4 percent — a sum of inflation target (2 percent) and annual average productivity growth from 2000-2019 (1.4 percent).

We would have to see both indicators trend down further, but it seems unlikely in the coming months. This is because two different forces are currently affecting wage growth. The quits rate — portion of people voluntarily quitting their jobs among the total employment number — has fallen to 2.2 percent in December 2023 from an April 2022 peak of 3 percent, indicating that wage rise opportunities are shrinking for job switchers. Such a move is positive for lower inflation ahead.

But on the other hand, those running individual businesses have plans to increase employee wages in the coming months. This provides an upside for wage growth particularly for job stayers. Overall, total wage growth is unlikely to slow in the near term.

Furthermore, within the non-housing services, components known as “sticky inflation” are rising again. Auto repair and insurance fees are rising by more than 1 percent per month in recent months. Medical insurance and hospital fees are rising as well. The former is due to more car accidents, automation of vehicles and longer ownership of vehicles. The latter is due to an increased usage of medical services by older people. Such inflation seems to be somewhat structural and unlikely to be controlled by higher rates. If all of these components are combined, it accounts for 6 percent of the total CPI basket.

Just like the Fed mentioned in its January 2024 FOMC meeting, we would need a greater confidence of disinflation becoming a trend, and this time driven from the service sector. Service-driven disinflation would have to push core PCE growth at least below 2.5 percent in order for the Fed to initiate its rate cut cycle. We expect this to take place as early as mid-second quarter of this year, and with the Fed backward looking, actual rate cut action is to take place in July.

Case for the BOK

The BOK is also likely to initiate its rate cut cycle in July. Korea is also witnessing wide-ranging disinflation, as most of the factors that created inflation reverse their course. That said, both headline and core inflation are to stay above 2.5 percent until the second quarter of this year, leading to a somewhat cautious stance for the nation’s central bank. In the second half, we would see inflation numbers sustainably coming in below 2.5 percent.

In addition, the central bank will confront increasing needs to address growth for domestic demand, as construction investment continues to provide a downside for the nation’s economy. External monetary policy conditions — i.e. the Fed’s cut — will also provide maneuvers for the BOK.

The writer is the chief economist at Meritz Securities in Seoul.