FOMC policy decision: Setting the predicate for rate cuts

REAL ECONOMY BLOG | January 31, 2024

Authored by RSM US LLP

The Federal Open Market Committee on Wednesday left is its policy rate unchanged between 5.25% and 5.5% and maintained the pace of quantitative tightening.

The committee, however, made major changes to the policy statement that implies a coming upward revision in its economic forecast and a shift in the balance of risks to the economy away from a tightening bias. It also removed the paragraph in the previous statement around risks to the banking system.

While we think that the Fed would prefer to wait until June to implement its first rate cut, the notable improvement in the inflation data and pricing outlook, and the anchoring of inflation expectations around the central bank’s 2% target, may result in a May reduction in a policy rate that is too restrictive.

Given that the Fed’s inflation metric stands at 2.9%, and that the three-month and six-month annualized pace is now 2%, it is clear that the time has come to change the policy statement to reflect the true risks to the economy.

The major change to the statement was in the policy paragraph where the committee inserted the following: “In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”

Yet the committee moved to dampen enthusiasm for a near-term rate cut in March by implying in its policy statement, the Powell press conference, and its statement on longer-run goals and monetary policy that it is not comfortable reducing the policy rate until the central bank is confident it is nearing its 2% inflation target.

While the Fed did not signal a willingness to reduce the pace of its quantitative tightening program, we expect the FOMC will reduce the pace of balance sheet reductions at its May meeting.

We estimate that the committee will reduce caps on reductions in its holdings of Treasury notes to $30 billion and caps on mortgage-backed securities to $20 billion in June. That implies that the Fed’s balance sheet, which peaked in 2022 at nearly $9 trillion, will fall to around $6.8 trillion by the end of the year.

We are certain that the meeting featured a discussion around maintaining the pace of reducing the Fed’s balance sheet. But the breadth and depth of that discussion will not be made available until the publication of the Federal Open Market Committee minutes on Feb. 21.

Powell’s remarks

Federal Reserve Chairman Jerome Powell was careful to note that the Fed has most likely reached the peak in its rate-hike cycle, and that the central bank will be likely to reduce rates later this year. He added, though, that the Fed needs to be confident of reaching its 2% inflation target before that occurs. In addition, he noted that most FOMC members want to reduce the policy rate this year.

Based on the current evolution of the personal consumption expenditures index, the Fed’s closely watched measure of inflation, that could be as soon as May which provides the Fed flexibility for when it begins the reductions.

Whatever the case, the Fed should be expected to move in a carefully calibrated and patient manner toward its ultimate goal of price stability and maximum sustainable employment.

The takeaway

The Federal Reserve shifted its bias on monetary policy away from tightening to a balance of risks that favors neither rate hikes nor cuts.

It is clear that the central bank likes where the economy is and thinks that the labor market has rebalanced. Now, with disinflation moving through the economy, it sees rate cuts on the horizon.

For these reasons, and with support of committee members, the Federal Reserve set the predicate for what we think will be a multiyear period of interest rate cuts until the policy rate rests between 2.50% and 3%.

We expect that upcoming policy meetings will remain “live” options for the Fed to begin its long-awaited rate cuts. We also expect that overall market liquidity will be improved once the Fed starts to reduce the pace of its quantitative tightening program that could begin as early as May.