Federal Reserve officials are preparing to leave their historic interest-rate raising campaign on hold next month for the third meeting in a row — but that does not mean they are ready to discuss cuts.
Since July the federal funds rate has held steady at a 22-year high of 5.25 per cent to 5.5 per cent, a level that policymakers have described as “restrictive” for households and businesses as the central bank seeks to curb demand across the world’s largest economy.
But officials have danced around two crucial questions: whether rates are now high enough to bring inflation down to the Fed’s 2 per cent target, and how long they must stay at a “sufficiently restrictive” level.
Those questions will remain unanswered when the Federal Open Market Committee convenes in mid-December for the final gathering of 2023. Fed officials are poised to leave open the possibility of more tightening while keeping prospective cuts at bay, even as the economic signals increasingly suggest the debate within the central bank will begin to creep in that direction.
The hesitation to officially declare the rate-rising phase of the inflation fight over, and address more directly the parameters for rate cuts, stems in part from concerns that doing so could unleash a wave of looser financial conditions that undermine the Fed’s efforts to rein in price pressures.
In one cautionary sign, US stock markets have rallied sharply in recent weeks as long-term interest rates have fallen — something Christopher Waller, a Fed governor, on Tuesday said serves as a reminder that “policymakers must be careful about relying on such tightening to do our job”.
That rally accelerated this week after Waller said he was “increasingly confident” that monetary policy was in the right place to achieve the Fed’s goals, and suggested rates could come down if inflation moderates “for several more months”.
Now, traders in futures markets wager the first cut will come in May, and that the policy rate will hover around 4 per cent by the end of next year, about a full percentage point lower than its current level.
Policymakers are also genuinely uncertain about how quickly inflation will cool and whether the recent string of better than expected data will prove fleeting — as was the case in 2021 — or if consumer price growth will plateau at an unacceptably high level.
Thomas Barkin, president of the Richmond Fed, on Wednesday warned that if inflation looks set to “flare back up, I think you want to have the option of doing more on rates”.
“I would be very surprised if anytime soon you heard commentary from somebody like the chair or others that ‘we’re done’,” Charles Evans, who retired from the Fed in January after serving 15 years as president of its Chicago bank.
John Roberts, who worked for 35 years at the Fed until his departure in 2021, added: “It’s definitely not time for a victory lap.”
Still, officials have been unable to deny that the data is starting to suggest they may have done enough to squeeze the economy. Consumer spending has begun to cool alongside business activity across both the manufacturing and services sectors. Demand for workers has ebbed, too, without causing serious cracks in the labour market.
Perhaps the most encouraging signal came from the October consumer price index report, which showed annual inflation had moderated to 3.2 per cent — more than analysts had expected — as cost increases slowed.
For rate cuts to be considered, officials need to be confident inflation is trending back to 2 per cent in a sustainable way. Powell said earlier this month that officials are not thinking about such policy action “right now at all”.
But Powell has previously offered up clues about the Fed’s thinking. He hinted in September that rate cuts could be warranted as inflation moderates, so the central bank’s policy settings do not become more prohibitive. Such an adjustment could resemble the series of cuts the Fed implemented over three meetings in 2019 — which it dubbed a “mid-cycle adjustment” — aimed at mitigating risks to the economy.
At minimum, the Fed likely needs to see several inflation reports that reflect a downward trend, as October’s CPI report indicated.
For Roberts, now a senior adviser at Evercore ISI, a “headfake-proof” threshold would be core inflation as measured by the personal consumption expenditures price index hitting a six-month pace of 2.5 per cent with wage growth also moving down.
“It’s not implausible that by mid-year inflation could be down to where the Fed would be wanting to cut,” he said.
A sudden, sharp downturn in activity could also influence the Fed’s approach, although staffers and officials are not expecting that.
According to individual forecasts published in September, policymakers predict just 0.5 percentage points’ worth of cuts next year with core inflation cooling to 2.6 per cent, slower growth of 1.5 per cent and a slightly higher unemployment rate of 4.1 per cent. Those estimates will be updated next month.
Economists at Deutsche Bank currently forecast the Fed will begin lowering its policy rate in June, bringing it down by a total of 1.75 percentage points by year-end, as the economy tips into a “mild” recession in the first half of 2024. UBS also anticipates the US economy to flatline around 0.3 per cent next year and expects cuts beginning in March.
Evans said: “They do have the ability now that inflation has come down that if the economy weakens, they can reposition the funds rate lower but still be restrictive in that environment.
“I think they have more policy options if they get into that situation [compared to] if inflation was closer to 4 per cent and they weren’t sure it was coming down.”