New Year: Markets want six rate cuts. They'll be disappointed

Wall Street enters 2024 in a state of euphoric anticipation, with forward markets pricing in six quarter-point interest rate reductions beginning as early as March. It is an enticing prospect, but one that sets investors up for profound disappointment. The gap between what financial markets want and what the Federal Reserve’s reaction function will tolerate has rarely been wider.

The Reaction Function Gap

For the Fed to deliver 150 basis points of rate cuts in 2024, the economy would need to experience either a rapid deterioration into recession or an immaculate collapse in service wage inflation. With GDP tracking above potential, unemployment below four per cent, and financial conditions loosening dramatically, aggressive easing would risk reigniting inflation. Central bankers will proceed with deliberate, frustrating caution.

Markets betting on six rate cuts are pricing in a monetary rescue that an economy operating at full employment neither requires nor will receive.