15 DEC, 2023
By Johanna Zidani from RankiaPro Europe
Finally, the Federal Reserve (FED) meeting has not brought surprises, and the body, led by Jerome Powell, decided to keep interest rates unchanged. This move marks the third consecutive pause. But what does this move mean, and what are the prospects for next year? Here are the opinions of fund management companies:
· The Fed acknowledged the improved inflation outlook and the slowdown in employment but was cautious not to fully comply with market expectations of a rapid pace of rate cuts. The appropriate policy rate for the end of 2024 was reduced by 50 basis points, implying a 75 basis points reduction from the current level (compared to the approximately 100 basis points priced by futures). The short-term inflation forecast was revised downward, and growth was revised upward, but the overall macro outlook changed minimally. The median neutral policy rate is still perceived at 2.5%, but the distribution of the projections leans heavily upwards.
· Chair Powell sounded rather optimistic on inflation and not overly concerned about the recent disinflation phase being particularly challenging. Risks are balanced, and the Fed is mindful of the risk of maintaining tight rates for too long. Nevertheless, he did not commit to a timing for the first rate cut nor precisely state the economic conditions that would trigger it.
· We maintain our view of a 100-basis point reduction next year; we anticipate the first cut in May when the Fed will have sufficient evidence on disinflation.
We believe that the Fed will be the last major central bank to cut rates (behind the ECB and the BoE). We expect general inflation to continue its downward trend throughout 2024, approaching the 2% target by mid-year. However, it is likely that core inflation will take a bit longer to decline, as the U.S. economy experiences a period of sub-trend growth rather than a genuine recession. Moreover, persistent risks stemming from demand resilience and employment conditions are likely to ensure that the Federal Reserve remains patient before easing its monetary policy, in order to ward off the threat of a second wave of inflation. In fact, we have pushed back our expectations and now anticipate the first interest rate cut by the Fed in September 2024, with a 200 basis point decline in rates to 3.5% in 2025, a little later than what the market is currently pricing in.
The Fed left the target federal funds rate unchanged at 5.25-5.50% (and all other rates unchanged) by unanimous decision, in line with our own expectations and those of the overall market.
In its accompanying statement, the Fed made minor adjustments to the economic description. It acknowledged signs of weaker growth, stating that "economic activity has slowed from its strong pace in the third quarter." However, its long-standing observation that "inflation remains elevated" was also modified to state that "inflation has decreased over the past year but remains elevated." This suggested additional emphasis on the level, regardless of the positive direction of the journey. Finally, the Fed gradually shifted the emphasis in its statement to state "in assessing the appropriate path of any further policy tightening," an adjustment that Powell confirmed was intended to signal a change in perspective.
At this meeting, summarized economic projections were updated. GDP forecasts were revised upward for 2023 to 2.6% following upward revisions in 3Q. If not revised, this suggests a quarterly growth of 1% annualized in the fourth quarter, in line with our own forecasts. Beyond that, the Fed's projections hardly changed. However, the Fed expects a slightly slower deceleration throughout 2024, with a rebound in 2025 slightly less than our own forecasts. Its unemployment assessment remained unchanged until 2025. The Fed now expects unemployment to stay at 4.1% in 2026, but this remains in line with its expectation for the long-term growth rate, which has increased. Short-term inflation expectations from the Fed were generally revised downward for 2023, aligning its forecasts with the market here. However, they were marginally lower in the following two years, and none of them are expected to return to the target until 2026 (though just above the 2.1% and 2.2% targets for the core in 2025).
The Fed made a more significant adjustment to its median rate forecast. This lowered the end-of-2023 rate to 5.4% (consistent with the 5.50-5.25% target range). It also increased its projected rate cuts to 75 basis points next year (down to 4.75-4.50%) and 100 basis points in 2025, with an additional 75 basis points reduction in 2026. The Fed left its long-term assessment unchanged. Figure 2 shows the expectations of each participant. The 2024 view range remained basically unchanged, just shifted downward. In 2025, despite the ranges still being broad, most participants were converging around a median outlook of 3%, and by 2026, there was a clear expectation of lower rates, primarily below 3%. There were few changes in the assessment of the long-term rate.
Fed Chair Powell addressed all relevant points in his press conference. He explained that rate hikes were not off the table but were not the "baseline scenario." He stated that inflation had progressed but that further progress was needed to ensure the Fed was on the right path, reiterating that "there is still a long way to go." Powell also reiterated the description of three tightening stages (how fast, how high, and how long), identifying the Fed as still in the second stage. However, Powell also said enough to suggest that the Fed was closer to changing rates than the forecasts indicated. Firstly, he said the third stage, i.e., how long and therefore when to cut, was in sight. Something, he said, the Committee "has debated today," although he then suggested that it was just a topic to be discussed. He also said that the Fed wanted to avoid "waiting too long" to prevent "making that mistake" of falling behind the curve again. He also claimed that potential growth could have exceeded 2.5% this year, something that, if true and persistent, could suggest continued significant easing of inflation with still robust growth, before reflecting on whether increases in participation and improvements in the supply chain may have run their course.
We assume the Fed would have wanted to gently push back market expectations of rate cuts soon and sharply next year. However, despite offering some necessary lines, Powell's broader commentary served the opposite. As a result, we have to assess whether this was by design or by accident. We are likely to see in the comments of other Fed participants in the remaining days of this year and early next year, and minutes later in January, if there is any attempt to reinforce a more cautious stance. We suspect this is likely. But there is now a risk of a more abrupt market adjustment than necessary. Our view is that the 75 basis points the Fed discounts for next year is its best current estimate of where rates should be at the end of the year. It is also consistent with our own view. But markets have a very different perspective, even more so after Powell's conference.
Fed Chair ended with a more technical question about quantitative tightening. He confirmed that rate cuts and QT are "on independent tracks" and suggested that with $3.5 trillion in reserves, they could still be considered sufficient. Powell confirmed they were not talking about changing the pace of QT at this stage. But next year will also bring a more significant debate about how low these reserves can be.
By RankiaPro Europe