Since March 2022 the United State Federal Reserve (Fed) has hiked interest rate by 500 basis points from 0.25% to 5.25%. This hiking cycle was in response to rising inflation brought on by the COVID-19 pandemic. Inflation in the US peaked at over 9.0%, the highest level since the 1980s. The theory of using interest rate hikes to combat inflation stem from a school of thought known as Keynesian economics developed by the economist John Maynard Keynes in the 1930s. Keynes advocated that during periods of high inflation central banks could hike the interest rate to discouraged borrowing and limit spending. This decrease in aggregate demand would relieve the pressure on rising prices and result in a decrease in inflation. Similarly, lower consumer spending is mirrored by lower business investment which in turn would lead to higher unemployment rate, less disposable income, and subsequently lower aggregate demand. This chain of events would also lead to a decrease in aggregate demand and lower inflation.

Since March of 2022 this has been the primary objective of the Fed and most major central banks worldwide. Figure 1. shows that the Federal Reserve has been successful in their objective. Inflation fell sharply from 9.1% in June 2022 to 3.0% exactly a year later in June 2023, before a slight stabilisation at 3.2% in October 2023. However, Figure 1 also shows that the labour force in the world’s largest economy has remained uncharacteristically strong in the face of such an aggressive hiking cycle. Unemployment in fact declined from 3.6% in March 2022 to 3.4% in April of 2023, before eventually weakening to 3.9% in October 2023.

Figure 1

The appearance of a successful rate hiking cycle could be undermined in 2024 if the labour market remains resilient. There is much hope that the Federal Reserve will begin to cut interest rates in 2024 in order to relieve the pressure on consumers. Interest rate cuts will help to support the economy and promote a soft landing. A soft landing is a cyclical slowdown in economic growth, without the economy entering a recession. However, interest rate cuts and the potential soft landing are most effective when there is slack in an economy, provided for by a higher level of unemployment. At an unemployment rate of 3.9% the US is close to full employment and as such the process of monetary easing (through rate cuts) could pose a significant risk of reigniting inflation.

Without significant interest rate cuts, which cannot occur while the labour market remains resilient, the likelihood of a soft landing seems diminished as the tools to mitigate the economic slowdown will be similarly limited.  Figure 2 shows that throughout 2022 and 2023 excess savings have helped sustain the economy, however, these savings are quickly diminishing. The depletion of these excess savings, coupled with the high level of interest rates, means that a recession is likely to occur sometime in 2024. While the labour market is beginning to show signs of weakening through a combination of soft employment Purchasing Managers’ Index (PMI) figures and a reduction in the scope of the US non-farm payroll employment gains, unless there are signs of a significant weakening central banks will be unable to cut rates as aggressively as needed in order to avoid a recession.

Figure 2

The US Federal Reserve’s aggressive interest rate hikes since March 2022 appear to have effectively controlled inflation. However, the strong labour market hampers the feasibility of rate cuts for a potential soft landing. The anticipation of 2024 rate cuts to spur economic growth is challenged by inflation risks due to near-full employment. With depleting excess savings and high interest rates, a 2024 recession seems likely. The weakening labour market, evident in soft employment figures, underscores the central banks’ need for a delicate balance of their monetary policy in the coming months.

Since the end of October, interest rates differentials have been moving against the dollar, with price momentum having turned negative. Based on these dynamics alone (and in the absence of a shock event), the dollar should weaken though 2024 until the recession starts. Once in a recession the dollar should find support once again and appreciate. See Figure 3.

Figure 3