Don’t fuel the flames
- The Federal Reserve will hold the federal funds rate unchanged at 5.25% to 5.50% during this week’s Federal Open Market Committee (FOMC) meeting, and the policy statement will likely be little changed.
- We believe policymakers will only change the negative conditionality statement (“the Committee does not expect …”) into a positive one once they’re ready to signal the onset of the easing. There won’t be a new dot plot, but a majority would currently favor two 25 basis points (bps) rate cuts or less in 2024.
- The Fed may announce plans to start tapering its quantitative tightening program in June while providing guidance on the desired timeline. We know from recent FOMC minutes that policymakers want to avoid repeating money market stress (as in 2019), and that they favor reducing the monthly pace of runoff by half by maintaining the existing cap on agency mortgage-backed securities while adjusting the redemption cap on treasury securities. We also know there is a preference for moving to a balance sheet that consists primarily of treasury securities in the long run.
- Fed communication in recent weeks has had a decidedly hawkish lean. In the face of elevated inflation uncertainty, policymakers have indicated increased reticence to easing monetary policy soon. Fed Chair Jerome Powell confirmed the broad sentiment pivot when he noted that recent data had clearly not given the Fed greater confidence that inflation would sustainably return to 2% — a necessary condition for the onset of the easing cycle.
- A key element to watch during the press conference is how Powell responds to questions about possible rate hikes and whether he reiterates that all policymakers continue to believe that the policy rate is likely at its peak for this tightening cycle and that it will be appropriate to ease policy at some point this year. While the contrarian view of Fed rate hikes has become trendy, we continue to stress that the bar for rate hikes is elevated.
- Overall, we believe that while there will likely be an inflation plateau around 2.5% in the coming months, it is not so far above 2% that it would warrant excessively tight monetary policy. Disinflation is still in place based on first principles and a laser-focused battle to rapidly bring inflation to the 2% target could do more harm than good for the US economy.
- With Powell indicating the Fed should allow restrictive policy further time to work and a clear majority of policymakers favoring two or fewer rate cuts, we expect only two 25bps rate cuts in 2024 in July and November.
Unfortunately, the Fed has put itself in a difficult position via its extreme data dependence and play-by-play policymaking. The recent confidence statement from Powell — noting that data had clearly not given the Fed greater confidence that inflation would sustainably return to 2% — along with New York Fed President John C. Williams stating that the Fed would raise rates if the data signaled a need for tighter policy weren’t newsworthy in isolation, but because they lean into the volatile market narrative, they are subject to misinterpretation.
The two key risks associated with the Fed’s extreme data dependence and play-by-play policymaking are that (1) excessive monetary policy restriction could represent a mistake leading financial conditions to tighten and the private sector to retrench and (2) an unexpected reversal of economic fortunes would force another Fed pivot.
Indeed, while economic activity has been consistently surprising to the upside for the past year, disappointing labor market developments or evidence of increased consumer prudence in the face of elevated costs and tighter credit conditions could lead to a sudden reversal in growth prospects and a whiplash effect in terms of market expectations for Fed policy.
