Why the Fed will not cut interest rates this year

Ahead of its June 14 monetary policy announcement, the Federal Reserve is wrestling with whether another interest rate hike is warranted in its fight against inflation. Financial markets go a step further, wagering on rate cuts in 2023. Vanguard economists using a machine-learning model make the case for no rate cuts this year.

Based on pricing for bonds and futures contracts, the markets expect the Fed to cut its policy rate by more than half a percentage point by year-end. But that's probably unrealistic, according to Asawari Sathe, a Vanguard senior economist.

"We believe inflation will continue to moderate but remain above 3% through year-end, and unemployment will trend higher to a still reasonable 4.5%," she said. "In that scenario, the Fed cutting its policy rate this year is unlikely."

In fact, Vanguard's model anticipates that the Fed won't be in a position to cut rates until the middle of 2024. To get inflation back toward the 2% target, there is currently a 38% probability of the Fed increasing rates in the near future, a 35% chance of a rate pause or hold, and only a 27% chance of a rate decrease.

"Our model suggests that it's nearly three times as likely that the Fed will raise its target for the federal funds rate or keep it on hold this year than that it will cut rates," Sathe said. "Our model's output underscores our conviction that the Fed's fight against inflation hasn't yet reached an inflection point."

"Vanguard's model uses 25 inputs in four broad categories—inflation, labor market, financial conditions, and global commodities—to produce probabilities for the direction of Fed moves in the near future," said Boyu (Daniel) Wu, a Vanguard senior investment strategist.

The model incorporates data from the present, six months ago, and 12 months ago—all to simulate the type of decision-making made by the Federal Open Market Committee that looks at trends to set policy rates, Wu said. "Backtested over a five-year period, the model has been 80% accurate in predicting Fed moves and 77% more accurate than the traditional Taylor Rule, which uses inflation and GDP data."

"The Vanguard model is unique in using both market and macroeconomic fundamentals as inputs," Sathe said. "For Fed moves well into the future, where we don't have current data as inputs, the model uses our economic team's in-house views as inputs."

As with any method of prognostication, there are no guarantees.

"If economic conditions become far worse than expected, the Fed may become dovish and start cutting rates sooner than expected, but we see that as unlikely," Sathe said.

In the meantime, the model provides a more accurate assessment of probabilities, allowing active investors to potentially position themselves better and passive investors to have more conviction to stay the course.

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