US reaction: Powell exacerbates cut expectations – accident or design ?

15 December 2023 (5 min read)

Key points:

Fed left rates on hold by unanimous decision.
Statement acknowledged softening in growth and progress in inflation, but that it remained elevated.
Fed shifted bias to state that it would determine “any” further tightening – additional hikes “not off the table, but not base case”
And Fed Chair Powell presented some of the right phrases to dissuade markets from aggressive rate cut pricing
However, Powell also said the FOMC had preliminary discussions about cuts and was wary of “making mistake” of “holding on for too long”.
These comments proved a red rag to a bull (market) with rates and equities markets surging.
We do not think this was the Fed intended – it was contrary to their forecasts.
We continue to suggest just three cuts next year from June, but relative to current market pricing that will deliver material disappointment if it proves correct.

The Fed left the Fed Funds target rate unchanged at 5.25-5.50% (and all other rates unchanged) by unanimous decision, in line with our own and wider market expectations.

In its accompanying statement the Fed made minor adjustments to the economic description. It acknowledged signs of softer growth, the statement saying “growth of economic activity has slowed from its strong pace in the third quarter”. However, its long-standing observation that “Inflation remains elevated” was also tweaked to state “Inflation has eased over the past year but remains elevated”. This suggested additional emphasis on the conclusion about the level, regardless of the positive direction of travel. Finally the Fed gradually shifted the emphasis on the bias of its statement to state that “ in determining the extent of any additional policy firming”, an adjustment that Powell confirmed was intended to signal a shift in outlook.

This meeting included updated Summary Economic Projections. GDP forecasts were revised higher for 2023 to 2.6% after the upward revisions to Q3. If unrevised, this suggests quarterly growth of 1% annualized in Q4, in line with our own forecasts. The Fed’s forecasts were barely changed thereafter. However, the Fed envisages modestly less of a slowdown over 2024, with a little less of a pick-up in 2025 than our own forecasts. Its assessment of unemployment was unchanged through 2025. The Fed now expects unemployment to remain at 4.1% in 2026, but this is still in line with its expectation of the longer-run growth rate, which it has edged higher. The Fed’s short-term inflation expectations were revised lower in headline and core terms for 2023, marking-to-market their forecasts here. However, they were trivially lower over the next two years with neither forecast to return to target until 2026 (although barely above target at 2.1% and 2.2% for core in 2025).

Exhibit 1: December’s Summary Economic Projections

The Fed made more of an adjustment to its median rate forecast. This lowered the end-2023 rate to 5.4% (consistent with the 5.50-5.25% target range). It also increased its expected rate cuts to 75bps worth next year (to 4.75-4.50%) and 100bps in 2025, with a further 75bps of reduction in 2026. The Fed left its longer-term assessment unchanged. Exhibit 2 shows the individual participants expectations. 2024’s range of views was basically unchanged, just shifted lower. In 2025, despite still wide ranges, most participants were narrowing in around a mid-3% outlook and by 2026 there was a clear expectation of lower, mainly sub-3% rates. There was little shift in the assessment of the longer run rate.

Exhibit 2: December’s policy rate projections (the dot plot)

Fed Chair Powell made all the relevant points in his press conference. He explained that rate hikes had not been taken off the table, but were not “the base case”; he said that inflation had made progress but that continued further progress was necessary to be comfortable that the Fed was on the right track, repeating that there was “still a ways to go”. Powell also repeated the description of three stages of tightening (how fast, how high and how long), identifying the Fed as still at the second stage. However, Powell also said enough to suggest that the Fed was closer to turning on rates than the forecasts suggested. First he said that the third stage – how long and thus when to cut – was coming into view. Something that he said the Committee “did discuss today”, albeit then suggesting this was only as a topic to be discussed. He also said the Fed wanted to avoid “holding on for too long” to avoid “making that mistake” of being behind the curve again. He also stated that potential growth could have exceeded 2½% this year – something that if true and persistent could suggest continued material easing in inflation with still solid growth - before musing whether participation increases and supply-chain improvements may have run their course.

We assume that the Fed would have wanted to gently push back on market expectations of rate cuts beginning soon and sharply next year. Yet despite delivering some of the lines necessary, Powell’s broader commentary has served the opposite (see below for extent of market reaction). Accordingly, we have to assess whether this was by design or accident. We will likely see in comments from other Fed participants in the remaining days of this year and early next, and minutes later in January whether there is any attempt to reinforce a more cautious stance. We suspect that this is likely. But this now risks a more abrupt market adjustment than necessary. Our view is that the 75bps the Fed prices for next year is its current best guess of where rates should be by year-end. It is also consistent with our own view. But markets have a very different outlook, more so after today’s conference.

Indeed, market reaction has been sharp. Short-term rates moved to price more cuts, the Fed is now almost fully-priced to cut by March having moved 10bps after Powell’s conference, November’s contract now suggests rates around 4.00% (more than 5 cuts) having dropped 30bps. 2-year UST yields fell 21bps to 4.46% and 10-year dropped 13bps to 4.03%. At the same time, the dollar dropped sharply by 1% and the S&P 500 index set a new record, briefly above 4700 before retracing to be still 1% higher.

The Fed Chair finished off with a more technical question on quantitative tightening. He confirmed that rate cuts and QT are “on independent tracks” and suggested that with $3.5trn of reserves, these could still be considered ample. Powell confirmed that they were not talking about changing the pace of QT at this stage. But a more meaningful debate about how low these reserves can be taken will also arise next year.

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