Written with AI: US Interest Rate Trajectory in 2024 and the Factors Behind Them
The game theory behind what the Fed might be thinking next year.
Author’s note: Before I start, I would just like to highlight what an incredible feat it is to be using AI to write a macro research article. As you read through the article below, notice how dense the information delivery is — this was made possible by very specific prompting from an economist’s POV. It basically summarizes the past 4 years of Fed monetary policy into less than 500 words, without sacrificing any detail. For reference, the original recording which I transcribed and subsequently edited this article from was over 30 minutes long — that’s how much material this ultra-dense article covers. AI was subsequently able to edit my sprawling thoughts going in every direction into a concise and coherent article with logical flow. I am truly in awe of its capabilities.
This article aims to delineate the Federal Reserve's (Fed) monetary policy stance in 2024, and its implications for various economic sectors.
The Fed's aggressive monetary expansion during the COVID-19 pandemic, characterized by a nearly 200% increase in the monetary base (M0), has precipitated a significant inflationary surge. This expansion, a form of quantitative easing (QE), was implemented to mitigate the economic fallout from the pandemic, involving direct fiscal transfers and subsidies to households and sectors such as healthcare and infrastructure. The resultant liquidity infusion bolstered aggregate demand, inadvertently contributing to the inflationary pressures observed in subsequent years.
In response to the inflationary uptick, the Fed has embarked on a contractionary monetary policy regime, elevating the federal funds rate from 0.25% to 5.50% in just slightly over 15 months. This policy shift, aimed at quelling inflation, has engendered a tightening of financial conditions with huge ramifications for the real economy. The banking sector has been particularly susceptible to these interest rate adjustments due to its short-term liability structure, experiencing immediate cost-of-capital increases and culminating in March’s implosion of SVB Financial.
Many companies in other industries with longer-term debt obligations are expected to confront refinancing challenges as they approach similar bullet repayments in 2024. This scenario is likely to precipitate a pronounced upward revision of loan rates, escalating interest expenses and potentially precipitating insolvencies, as evidenced by precedents such as Spotify.
It’s worth noting that the Fed's primary objective is to anchor inflation expectations, rather than to target inflation per se. This strategic focus is informed by historical lessons from the Volcker era, underscoring the self-fulfilling nature of inflation expectations and their influence on business pricing strategies. Consequently, the Fed's policy calculus is predicated on managing anticipatory inflationary psychology to forestall a wage-price spiral.
As a result, the Fed is likely to entertain one of two divergent policy trajectories in 2024:
a Reduction in interest rates to alleviate refinancing pressures and prevent widespread bankruptcies; or
the Maintenance of elevated rates to contract the expanded monetary base and mitigate inflationary risks.
The latter approach, which entails quantitative tightening (QT), is operationalized by increasing the cost of capital, thereby reducing excess liquidity in the economy and realigning the monetary base closer to pre-pandemic levels.
The market, however, is pricing in multiple rate cuts for the next year, a reversal akin to the rate hikes observed over the past two years. This expectation reflects a sentiment that the Fed may pivot towards a more accommodative stance in 2024, especially in light of expected economic distress precipitated by the current high-interest rate environment.
In conclusion, the Fed's policy trajectory for 2024 is contingent upon a delicate balance between mitigating inflation and sustaining economic growth. The Fed may face a policy conundrum, having to choose between continued QT to address the inflationary overhang from the pandemic-induced monetary expansion; or easing interest rates to prevent a cascade of corporate defaults and economic contraction. The Fed's decision will hinge on its assessment of inflation expectations and the broader economic impact of its policy stance.