Fed Funds Rate Update

Following the meeting of the Federal Reserve's Open Market Committee (FOMC) yesterday, we updated our forecast path for the fed funds rate (see "Persistent Above-Target Inflation Will Delay The Start Of Rate Cuts In The U.S.," published May 1, 2024). Specifically, S&P Global Economics now sees the first rate cut this cycle coming in December 2024, roughly two quarters later than our previous forecast. The cumulative amount of rate cuts that we expect remains unchanged at 250 basis points (bps), although we see the terminal policy rate for this cycle now being reached in the second half of 2026. Consistent with this policy rate forecast change, we also updated our forecast for key U.S. government and market rates (see table 1).

Table 1

The revisions to our U.S. rate expectations have a material impact on some other economies we cover. This comes through two potential spillover channels. First, policy rates in some relatively smaller, more open, U.S.-dollar-dependent economies are at least partly conditional on what the Fed does. In these economies, deferred Fed easing may result in domestic policy rates falling more slowly. Second, higher-for-longer rates in the U.S. can affect exchange rates (along with growth differentials), potentially depreciating currencies in the rest of the world.

Developed Europe And The U.K.: Monetary Policy Path Largely Unchanged

Today, we can see that the reassessment of expectations regarding U.S. monetary policy has led to a slight depreciation of European currencies (less than 5 cents) and a modest tightening of financial conditions, with yields on European sovereign bonds rising much less than those on U.S. Treasuries (see chart). This subdued reaction in European yields is largely because most European central banks have announced their intention to start cutting policy rates soon--in June for the European Central Bank (ECB) and probably in May for the Riksbank--or have already done so, as the Swiss National Bank (SNB) did in March.

We don't think that the latest Fed announcement will postpone most central banks' rate cuts. The Fed's change of scenario could perhaps have the most impact on the Bank of England (BoE), allowing a slower pace of rate cuts in 2025, but this will mostly depend on labor market developments and domestic price pressures.

European currencies and long-term rates are close to the levels we envisage in our base-case scenario for the second quarter of this year. Advanced European GDP figures published for the first quarter are largely in line with our expectations (apart from Spain, which once again surprised on the upside). For all these reasons, we confirm our current scenario. However, upside risks to European long-term yields have increased, with the scale of potential revision not exceeding 30 bps to 40 bps over 2025 compared with our current assumptions.

Central banks in Europe will probably seek to communicate with the markets to shield the European curve from potential rises in U.S. long-term yields. Against this backdrop, the Fed's announcement that it will slow the pace of reductions in holdings of U.S. Treasuries from June onwards is a factor mitigating the risk of an unwarranted tightening of financing conditions in Europe.

Monetary policy transmission

U.S. monetary policy is notably transmitted to the European economy through exchange rates and financial conditions. European currencies tend to depreciate against the dollar when U.S. interest rates rise relative to their European counterparts. The depreciation of European currencies is a double-edged sword. It can contribute to inflation--given, for example, that Europe imports more than half of its energy consumption. But it also favors exports, as foreign trade represents a substantial share of GDP in the EU or the U.K. The contractionary effect of currency depreciations on GDP is generally dominant in the short term via inflation but is mitigated or even reversed in the medium term--if the depreciation is sustained, thanks to the increase in exports.

U.S. rates also influence financial conditions in Europe. A relative increase in U.S. long-term rates compared with European rates may trigger a transfer of European savings to the U.S., and thus an increase in European long-term yields.

Asia-Pacific: Slower Rate Cuts Ahead

The prospect of later U.S. policy rate cuts has significant implications for the outlook for interest and exchange rates in Asia-Pacific (APAC). We expect most APAC central banks to delay and slow their policy rate reductions compared with our earlier expectations. This reflects the sensitivity of capital flows and exchange rates in the region to interest differentials with the U.S.

Several central banks want to contain depreciation pressure to limit the impact on inflation via higher import prices. We think some will adjust their plans to the new U.S. rates outlook to avoid currency weakening from encouraging capital outflows. Generally speaking, the revisions to our exchange rate projections are largest where we don't make major adjustments to the policy rate forecast, such as for Japan (we only adjust the timing of next Bank of Japan rate increase to 2024 from 2025).

Table 2

Table 3

Emerging Markets (Excluding Asia): Monetary Policy Normalization Will Take Longer

We now expect a slower process of monetary policy normalization in most major emerging markets (EMs). The interest rate differential between EMs and the Fed is a main determinant of capital flows, therefore influencing external accounts and exchange rates. Consequently, changes in the exchange rate can affect inflation through pass-through effects (increasing/decreasing the price of imports).

Monetary policy in most EMs is currently restrictive as central banks continue their effort to ensure inflation falls toward their respective targets. A delayed start to fed rate cuts will likely affirm EM central banks' determination in anchoring inflation expectations--meaning the process of shifting monetary policy to neutral from restrictive will take longer than previously assumed. Our terminal interest rate projections remain unchanged.

Central banks that are in the latter stages of their monetary policy normalization cycle, such as the central banks of Brazil, Chile, and Peru, will likely slow the pace of interest rate cuts in the coming months. Central banks that have just started reducing interest rates, such as Mexico's, will likely pause for some time before resuming monetary policy normalization later this year. Central banks that have not started reducing reference rates, such as South Africa's, will likely take longer to begin doing so.

At this point, we do not expect major changes in the exchange rates of EMs outside of Asia, which already assume modest depreciations versus the U.S. dollar this year, for two reasons. First, most of the impact of higher U.S. interest rates will be absorbed by a similar magnitude in higher interest rates in EMs (interest rate differentials will remain broadly unchanged). Second, delayed fed rate cuts come in an environment of strong U.S. growth, which is a positive development for several major EMs, as well as for capital flows to those economies.

Table 4

Our Forecasts Generally Held Firm

Despite the changes to our rates and currency expectations, our current forecasts for real variables across all of the countries we cover remain the same. We also affirm the accompanying macroeconomic narrative (see "Global Economic Outlook Q2 2024: Still Resilient, With Gradual Rate Cuts Ahead," March 28, 2024). In our view, any revisions to real variables stemming from our revised rate and currency forecast do not deviate significantly from what we expected at our March 2024 Credit Conditions Committee.

We plan to update our full macro view and narrative in the upcoming June Credit Conditions Committee.