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For weeks ahead of their final meeting of 2023, Federal Reserve officials appeared to have one goal in mind: keep as much flexibility over monetary policy as possible to finish off what has become an arduous fight to tame inflation.
On Wednesday, chair Jay Powell changed the tune.
Between a new tone in the policy statement, fresh projections indicating a less aggressive path for interest rates, and Powell’s own commentary during a press conference, the signals pointed in one, consistently dovish direction.
The shift overshadowed the US central bank’s other, more expected announcement on Wednesday, that it was again holding rates at current levels for a third meeting in a row.
Rather, not only did the Fed indicate that its multiyear campaign to tighten monetary policy was now drawing to a close, but officials also began entertaining sharper cuts to borrowing costs next year — a move designed to clinch a soft landing for the world’s largest economy.
Together, this brought joy to Wall Street, with stocks rallying and government bond yields falling. By Wednesday evening, the yield on the 10-year Treasury had dipped below 4 per cent for the first time since August.
Traders in federal funds futures markets increased their bets that the central bank could begin slashing the benchmark rate as early as March, and that rates could end next year below 4 per cent, well below their current level of 5.25 per cent to 5.5 per cent, a 22-year high.
But at a time when the inflation outlook still remains so uncertain, economists said this was exactly the kind of exuberant outcome the Fed needed to avoid, or risk making its own job of fully taming price pressures more difficult.
The fear is that looser financial conditions that bring about a cheaper cost of capital could unleash another wave of borrowing and spending by businesses and households, undoing some of the central bank’s work to restrain demand and cool the economy.
“It may make the last mile [of getting inflation down to target] harder, because they will not have financial conditions as tight as they need,” said Vincent Reinhart, who worked at the Fed for more than 20 years and is now at Dreyfus and Mellon.
“Investors are like the kids in the back seat saying, ‘are we there yet’ and they are just going to keep saying [that] at every meeting and their pricing will make the journey longer.”
The primary risk for the Fed is if the economy — and its robust jobs market — continues to defy expectations of a slowdown, in turn keeping inflation from falling as quickly as officials now expect, said Dean Maki, chief economist at Point72 Asset Management.
“It’s not so obvious that the labour market right now is consistent with the Fed’s 2 per cent target,” he said, referring to the central bank’s inflation goal. “I think there is a risk to the strategy at this stage without seeing more inflation or labour market data.”
While monthly jobs growth has cooled recently, demand for workers in industries from leisure and hospitality to healthcare remains strong. Those sectors could sustain a brisk pace of hiring and consumer spending, said Maki.
Powell alluded to those risks on Wednesday, saying it remained “premature” to declare victory over inflation and that further progress “can’t be guaranteed”.
But while he reiterated that the central bank could raise rates again if necessary, Powell’s warning rang hollow.
One reason was a change in the Fed’s statement, where it cited the conditions under which it would consider “any” additional tightening.
“We added the word ‘any’ as an acknowledgment that we are likely at or near the peak rate for this cycle,” said Powell.
That view was backed up by projections released on Wednesday that showed most of the central bank’s officials did not think rates would rise further and that they did expect more cuts next year than shown in the previous “dot plot” of their projections released in September.
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They now anticipate the policy rate falling by 0.75 percentage points in 2024 and another full percentage point in 2025, before it stabilises between 2.75 per cent and 3 per cent in 2026.
Powell did not spell out which criteria the Fed would use to decide when to start cutting but he did indicate that officials would take into account falling inflation, to make sure rates did not stay too high for households and businesses.
The central bank was “very focused” on not waiting too long to cut rates, he added.
Wednesday’s shift was made possible by officials’ more benign outlook for inflation, as well as expectations for slower growth and marginally higher unemployment next year. Powell also said that the effects of rising rates since March 2022 have yet to be fully felt across the economy.
Michael de Pass, head of linear rates trading at Citadel Securities, said this helped to explain why the Fed did not seem too concerned about looser financial conditions.
“It seems like they are taking comfort in the pace of the decline in inflation, taking comfort in the fact that they believe the current level of rates is fairly restrictive and taking comfort in the fact that there is still some tightening in the pipeline that hasn’t made its way through,” he said.
Source: Economy - ft.com
