The decision to hold the federal funds rate steady was in line with expectations, but the accompanying statement and projections indicate a shift toward easing in 2024.
As expected, the Federal Reserve kept the target range for its policy rate—the federal funds rate —unchanged at 5.25% to 5.5% at its latest meeting. The decision was unanimous. While the decision to hold the fed funds rate steady was in line with expectations, the accompanying statement and projections point to a shift toward easing in 2024. In addition, Fed Chair Jerome Powell's comments in his press conference confirmed that most members of the committee believe that the hiking cycle is over, and they discussed the path to lower rates.
Inflation is the key to the policy pivot
Encouraged by declining inflation, the Federal Reserve's Open Market Committee (FOMC) signaled that more rate hikes are unlikely in this cycle and that there could be 75 basis points in rate cuts in 2024. The statement that accompanied the Fed's decision indicated that "growth of economic activity has slowed since the third quarter" and "inflation has eased over the past year." In the accompanying Summary of Economic Projections (SEP), the median estimate of Fed officials suggests three rate cuts of 25 basis points each in 2024, bringing the fed funds rate to 4.6%. That compares to an estimate of 5.1% as recently as last September.
The shift in the Fed's projections brings them much closer to what the markets had been expecting compared to its previous projections. The "dot plot," which shows each member's estimates for the fed funds rate going forward for the next several years, indicates much more optimism about inflation heading back to target in the next few years. For a Fed that has been cautious about presenting an aggressive inflation-fighting stance, the change in tone was notable and was reflected in a strong rally in the bond market.
The Fed's quarterly economic projections suggest declining inflation.
The Fed appears on a track to "normalizing" interest rates—moving from a tightening stance to a more neutral stance. At neutral, the Fed hopes to have rates at a level consistent with slowing growth and inflation at 2%.
Since the last FOMC meeting, the benchmark inflation measure that the Fed uses—the deflator for personal consumption expenditures excluding food and energy (core PCE) has declined. It has trended steadily lower over the past year and now stands at just 3.5% compared to a peak level of 5.6% in this cycle. That progress appears to be encouraging the Fed to begin rate cuts sooner rather than later.
If the Fed left policy unchanged for a long time period as inflation declined, then real interest rates—adjusted for inflation—would continue to climb, exerting more pressure on economic growth. Real interest rates are already at the highest levels since 2008. Therefore, to some extent, Fed rate cuts are just aimed at preventing real interest rates from rising to even higher levels, risking a recession.
The Fed's economic projections indicate that the committee expects a modest rise in the unemployment rate, but not in the range that would suggest a recession forecast. Fed Chair Powell suggested in his press conference that the labor market is "coming back into balance." Given the Fed's mandate to aim for full employment along with low inflation, this is the "soft landing" scenario that the central bank has been seeking.
Quantitative tightening continues
The prospect of lower short-term interest rates is positive for the economic outlook and financial markets. However, the Fed does plan to continue to reduce the size of its balance sheet by allowing bonds it holds to mature without reinvesting the principal. The balance sheet has already fallen by more than $1 trillion from its peak. Continuing with quantitative tightening "in the background" may prove more difficult long-term if the economy slows down more than anticipated. However, for now, the reduction plan seems to be working without disrupting financial markets.
Financial markets responded positively to the surprisingly "dovish" projections from the Fed. Markets often make big moves at turning points. With rate cuts now on the horizon, yields of all maturities should continue to trend lower as the Fed looks to get to a more "neutral" interest rate. Two-year Treasury yields are nearly 80 basis points off the cyclical highs while 10-year treasury yields are nearing 4% after having touched 5% in late October. In the near term, the market reaction may be somewhat overdone, and we do expect volatility ahead, but we continue to be optimistic about the prospects for returns to fixed income investors in 2024.
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