A key indicator used by officials to set interest rates suggests rates could fall by 175 basis points over the next nine months. If that happens, then the prices of Bitcoin and ETH could rise, Scott Garliss said.
The Fed has plenty of room to start cutting rates.
Most investors don’t understand the true dynamics behind central bank interest rate policies. But these drivers are key to determining the rise and fall of risky asset prices such as cryptocurrencies and stocks.
The consensus on Wall Street is that the Fed will cut overnight borrowing costs to 3.33% over the next 18 months from the current 5.33%. This means that as money becomes more abundant and accessible, it will be cheaper for households, businesses and asset managers to borrow and more money will be available for investment.
The change would boost the value of dollar-denominated assets such as Bitcoin and Ethereum.
Over the past few weeks, we have seen encouraging signs that our central bank can start lowering interest rates again. One of the most important of these signals came in mid-August, when the U.S. Bureau of Labor Statistics released its Consumer Price Index (CPI) data for July. The data showed that inflation had fallen back below the 3% threshold for the first time since the beginning of 2021.
Fed Chairman Jerome Powell confirmed the shift last week. Speaking at the Kansas City Federal Reserve's annual economic symposium in Jackson Hole, Wyoming, he said it was time to start lowering interest rates. He noted that inflation growth had slowed enough to allow for the shift. He said supply chains returning to normal and a rebound in the labor supply had eased price pressures.
However, there is a more important factor at work. Real interest rates have rebounded to their highest level in nearly two decades. This change tells our central bank that it has a downside buffer to start cutting rates now. In other words, it can lower interest rates and still slow inflation and support stable economic growth.
If you're not familiar, real interest rates are a key metric the Fed uses to see whether monetary policy is driving inflation higher or lower. Officials can see this by comparing the effective federal funds rate (the rate at which banks borrow money overnight) to the CPI. If the difference is negative, policy is spurring too much growth. If it's positive, it means interest rates are dragging down prices.
The chart above compares the effective federal funds rate (blue line) and the CPI (orange line) since 2000. You'll notice that in the periods preceding rate cuts, the federal funds rate was typically above the CPI. And in the periods preceding rate hikes, the rate was below the rate of inflation.
The red line is the interest rate differential we discussed above. Notice on the far right, in June 2022, the real interest rate was -8.3%. In other words, policy was very weak and had no effect on prices. At the time, the effective federal funds rate was close to zero, while inflation growth peaked at 9.1%. So, shortly thereafter, the Fed began an aggressive series of rate hikes to regain control of price growth.
If we look at the far right side of the chart above, we can see that things have changed a lot. After raising interest rates from 0% to the 5.3% range, our central bank has changed the trend of price growth. Since the peak in June 2022, the CPI has fallen from 9.1% to 2.9% in July this year. In the process, real interest rates have risen all the way back to 2.4%. In other words, policy is putting pressure on prices.
Right now, real interest rates haven’t been this high since July 2007. That was right before the Fed started cutting rates again.
But how can we ensure that it reduces interest rates without sparking inflationary growth again?
We can look at the average CPI growth rate over the past six months, which happens to be 0.2%. We can then project the annualized rate for the next year based on the Bureau of Labor Statistics index data. Finally, we can compare that to Wall Street's implied federal funds rate for the next year to see what the actual rate will be.
As I mentioned at the beginning, fund managers expect the Fed to cut rates quickly. They expect the effective federal funds rate to fall from the current 5.3% to 3.7% by April 2025. This is a huge turnaround in less than a year.
However, inflation growth could also fall sharply over the same time frame. Based on the 0.2% average over the past six months, the annualized CPI rate could reach 1.9% when data is released in April 2025. This would be the first time it has been below the Fed’s 2% target since February 2021.
More importantly, these changes mean that the Fed can cut rates by 175 basis points over the next nine months and still have an effective interest rate of 1.8%. This tells us that despite a possible round of easing in the short term, monetary policy will continue to weigh on price growth.
The impact of this change on economic sentiment is huge. Homes and real estate purchased at high interest rates in the past few years can be refinanced, thereby reducing the interest payment rate for individuals and businesses; the cost of items such as houses and cars will fall, making them more affordable; and the repayment burden of items such as credit cards will be reduced. These changes will provide institutions and individuals with more funds to spend.
As this happens, economic sentiment will shift from being on the brink to being able to maintain steady growth. This shift will support solid earnings growth for U.S. companies. And the Fed still has room to cut interest rates further if it deems adjustments necessary.
Ultimately, stable economic growth and improved consumer and business confidence will encourage retail and institutional investors to invest more in risky assets. In other words, this change will drive up the prices of Bitcoin and ETH.
