FOMC preview: Modest adjustments will lead to pivot by midyear

REAL ECONOMY BLOG | January 26, 2024

Authored by RSM US LLP

The FOMC next week will almost certainly leave its policy rate unchanged between 5.25% and 5.5% and maintain the pace of quantitative tightening.

The hold in the policy rate should be understood as the Federal Reserve again signaling that it considers rates sufficiently restrictive to bring down inflation and that the central bank’s rate hikes have ended.

Since the Fed’s last meeting, financial conditions have eased considerably and the RSM US Financial Conditions Index has moved into neutral terrain implying that financial conditions are neither a drag nor accommodative on overall growth.

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

We anticipate that the committee, in its statement, will adjust the sentence that reads, “in determining the extent of any additional policy firming that may be appropriate to return inflation to 2 percent over time” to read, “sufficiently restrictive in determining appropriate policy to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

By doing so, the committee will be communicating that the risks with respect to the direction of policy are balanced as opposed to tilted toward further rate hikes Such a view, in central bank parlance, will be interpreted laying the groundwork to make the Fed’s long-awaited pivot.

In addition, we expect the Fed to remove the paragraph on the U.S. banking system and financial conditions. Given that the central bank is ending its Bank Term Funding Program, which was put in place to ease the stress in the banking system last spring, when it expires on March 11 and given the easing in financial conditions, that text is not moot.

Beyond that, we anticipate no other major changes to the policy statement.

The meeting will provide a discussion around maintaining the pace of reducing the Fed’s balance sheet, known as quantitative tightening. The breadth and depth of that discussion, however, will not be made available until the publication of the Federal Open Market Committee minutes on Feb. 21.

Our base case is that the FOMC will reduce the pace of quantitative tightening 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.

While the January meeting will reinforce the notion that the central bank is on pause and will be patient in moving to cut rates, the central bank remains sensitive to rate expectations which currently are pricing in a first rate cut in May and 140 basis points of rate cuts overall.

That should be the basis of the Federal Reserve Chairman Jerome Powell’s news conference in which he will be pressed, given the personal consumption expenditures index has slowed below the Fed’s target of 2% over the past six months and has a legitimate shot of reaching that level in the near term.

It will be difficult for Powell to strike a balance between the forward look that central bankers must provide to an impatient investment community and a public that still expects inflation growth well above actual inflation.

Although we anticipate Powell will be cautious and choose to signal patience on inflation and the coming policy pivot by the time we get to the March meeting, it will be near impossible for Powell not to sound ultra-dovish given the underlying dynamics of easing inflation, solid growth and the improvement in wages and hiring.