Why it’s time to cut interest rates

It looks as if the US economy, and by extension South Africa, may achieve the rarest of feats — a soft landing — with financial markets pricing in high odds of both the US Federal Reserve and the Reserve Bank starting their rate cutting cycles in September. 

In fact, many local economists are pricing in four rate cuts from the Bank between now and the middle of next year, up from three previously. This is after South African consumer inflation for July significantly undercut consensus expectations by coming in at just 4.6%, down from 5.1% previously — its lowest level in three years. 

The upshot is that the Bank will have to revise down its inflation outlook at its September 19 monetary policy committee (MPC) meeting, and if the Fed starts cutting at its meeting on September 18, as the markets strongly expect it will, the Bank should have little reason not to follow suit. 

A soft landing would require US economic growth to slow, but not enough to cause a recession, while allowing inflation to cool, thereby creating enough room for the Fed to cut interest rates from elevated levels and sustain an ongoing mild expansion, explains Old Mutual Wealth chief investment strategist Izak Odendaal. 

Despite the wobble in early August, when markets overreacted to one bad US unemployment number, the decline in US inflation from 9% in mid-2022 to 2.9% in July 2024 has been “remarkably painless”, he adds. The US economy has continued to grow, and unemployment has hovered near record lows. 

In retrospect it now seems that the spike in the July US unemployment data to 4.3%, which fuelled global panic that the world’s largest economy might already be in a recession, was due partly to the temporary dampening effect of Hurricane Beryl. The subsequent release of robust retail sales data for July, coupled with a mild July US inflation print, has allowed markets to recover their equilibrium.

“The demise of the US consumer has been greatly exaggerated,” opined Barclays Research in an economics note. “The resilience narrative is alive and well.” 

And yet, heightened awareness of the downside risks to global activity, coupled with more favourable US inflation data, has now opened the door for a full-blown central bank easing cycle that is likely to pick up steam in the months ahead, says Citi global chief economist Nathan Sheets.  

In fact, he notes that many central banks, including the banks of Canada, England and Mexico, have already started to cut, with the prevalence of global monetary policy easing now at its highest in the past two decades outside of a global recession.

“All told, while the last mile in the inflation battle still may pose challenges, the upside risks to global inflation look less pronounced than they have been for much of the past few years,” says Sheets. 

Odendaal agrees that despite the August market spasm, the US still appears on track for a soft landing. But this would be “a rare feat”, he adds, given that most of the Fed’s interest rate hiking cycles since World War 2 have ended in hard landings. 

After Fed chair Jerome Powell dialled up the dovish rhetoric at the Jackson Hole Economic Symposium on Friday, London research business Capital Economics now believes the choice is no longer between whether the Fed will cut or not in September, but whether it will be a 25 basis point (bp) or a 50bp cut.

Markets are now pricing in a two-thirds chance of a 25bp Fed cut in September vs a one-third chance of a 50bp move. 

“That seems about right to us,” says Capital Economics economist Stephen Brown, noting the potential for the August employment report to provide a more positive signal on the labour market. 

Capital Economics has updated its forecast to include an additional 25bp rate cut from the Fed this year. In total it expects the Fed to cut by a cumulative 200bp — a 25bp cut at every meeting until the federal funds target range bottoms out at 3.25%-3.5% in mid-2025. That should support a broad-based pickup in GDP growth from next year. 

Similarly, in South Africa the emerging consensus is that with headline CPI now almost at the midpoint of the target range, and core inflation already below the midpoint, at 4.3% in July (down from 4.5% in June), the Bank will likely cut rates at both the September and the November MPC meetings.

The markets have even started to price in the possibility that the Bank could front-load its easing cycle by kicking off with a 50bp rate cut, though the expectation is still for total cumulative easing of no more than 100bp-125bp.

An initial cut of 50bp would not be unwarranted, given that the real policy rate has become significantly more restrictive since the big drop in inflation in July, but such a bold, sudden move would be uncharacteristic of South Africa’s cautious, hawkish Bank.

Nor is it necessary, according to Citi economist Gina Schoeman.

“Inflation is set to move consistently lower over the coming months, but nothing is driving it to worryingly low levels that signal the necessity of a sudden stimulus,” she says. “Consistent consecutive 25bp rate cuts would work well to remove restrictive monetary policy and remind everyone that, structurally, the floor of inflation remains too high.”

Absa senior economist Miyelani Maluleke also sees a 50bp move as unlikely. However, much will depend on the evolution of data, with the August CPI print and the next inflation expectations survey being absolutely “critical”. 

Momentum chief economist Sanisha Packirisamy is expecting four 25bp rate cuts from the Bank, starting in September. She says: “Against the favourable July CPI print, the improved inflation trajectory, moderating inflation expectations, a stronger rand and muted demand-pull inflation, we maintain our stance that the Bank will cut interest rates by 25bp in the September 2024 meeting to 8% and will follow with three more cuts of 25bp each by the middle of next year.”  

All this explains why the JSE (and the FTSE 100 and the S&P 500) have been trading at record highs and the rand firmed below the R18/$ handle last week. 

Absa’s latest CPI forecasts suggest inflation will dip below the 4.5% midpoint of the target band by the fourth quarter

And yet South Africa came within a whisker of experiencing its own hard landing in the first half of the year: the economy contracted by 0.1% in the first quarter while the unemployment rate jumped from 32.9% to 33.5% in the second quarter. 

The country was, however, pulled out of a potential downward spiral by the peaceful May election and the formation of a centrist government of national unity (GNU) that has rallied behind pro-growth economic reforms. The cessation of load-shedding and the slowing of inflation have also helped to lift the country’s growth outlook. 

Absa currency strategist Mike Keenan believes an extended rand recovery is likely on the back of South Africa’s improving fundamentals; he expects the currency to end the year at R17.50/$. 

“While we acknowledge that a renewed bout of global market volatility poses a risk to such a recovery, we ultimately expect risky assets and commodity currencies such as the rand to benefit from a more accommodative global monetary backdrop in the coming quarters, provided that [Fed] rate cuts help to avoid a US recession,” he says. 

Absa’s latest CPI forecasts suggest inflation will dip below the 4.5% midpoint of the target band by the fourth quarter due to lower fuel and food price assumptions.

Consequently, it now also expects the Bank to deliver 100bp of cumulative rate cuts (previously 75bp) from September 2024 (previously from November) to March 2025 in four moves of 25bp at each MPC meeting. 

Until now, emerging-market fund managers have been somewhat reluctant to buy rand assets aggressively, but that should change when the Fed starts cutting rates, says Keenan. 

Critically, Absa expects South Africa’s real policy rate to increase relative to the US’s over the coming quarters because though both central banks are likely to cut at the same pace, it believes that domestic inflation is likely to fall faster than US inflation. This widening differential should help support the rand. 

But as far as attracting foreign equity inflows goes, it seems these will gain traction only when the country’s GDP numbers actually improve. 

That, of course, is the real test. Should the GNU struggle to accelerate the structural reforms necessary to revive business confidence and catalyse private fixed investment, South Africa’s nascent growth momentum could stall. 

These, then, are the two main risks to the soft-landing scenario: that the Fed fails to cut rates timeously, pushing the US into a protracted recession; and that the GNU fails to revitalise the economy, so that South Africa follows the US downhill.

Fortunately, this is not the consensus. But investors will doubtless remain a tad jittery until those first September rate cuts are finally in the bag.