The Federal Reserve’s Federal Open Market Committee (FOMC) is widely expected to leave interest rates unchanged at the conclusion of its two-day policy meeting on Wednesday. However, investors are closely watching for signals that the central bank is preparing to pivot towards an easing cycle, with rate cuts potentially on the table as early as the next meeting in March.
Inflation cooling rapidly, giving Fed room to maneuver
A driving force behind market expectations for Fed easing is the rapid cool-down in inflation over the past six months. After peaking at 9.1% in June 2022, the consumer price index has steadily declined, clocking in at just 3.2% in December.
The post-pandemic surge in inflation prompted the Fed to aggressively hike rates last year from near zero to over 4.5%. However, with inflation now clearly on a downward trajectory towards the Fed’s 2% target, policymakers have room to halt or even reverse some of that tightening.
“Inflation has come down quite a bit and the economy seems to be slowing. To me that means the Fed can ease off the brake a little bit.” – Robert Frick, corporate economist at Navy Federal Credit Union
Growth concerns add pressure for Fed to turn dovish
In addition to cooling inflation, increasingly gloomy signals around economic growth are strengthening arguments for a less hawkish Fed.
Q4 2022 GDP expanded at just a 1.0% annualized pace, sharply missing estimates – an indication that the Fed’s rate hikes are beginning to bite and significantly slow activity. Meanwhile, tech giants like Google, Amazon and Microsoft have all announced major layoffs, pointing to weakness in labor markets.
Janet Yellen and other Democratic policymakers have strongly urged Fed Chair Jerome Powell not to overtighten and risk sparking a recession. The pressure is on for the Fed put growth concerns ahead of further disinflation.
Markets betting on rate cuts starting in March
Futures markets are currently pricing in a 77% probability of at least a 25 basis point rate cut at the March FOMC meeting. Traders will be parsing this week’s statement, forecasts and Powell’s press conference for confirmation that cuts are on the table.
FedWatch Tool projections for March meeting:
|Rate cut probability
|Implied fed funds rate after March meeting
|4.25% – 4.50%
|4.50% – 4.75%
Markets will likely react negatively if the Fed pushes back against expectations for cuts beginning shortly. However, analysts widely believe Powell will strike a dovish tone that opens the door for imminent easing while falling short of firmly committing to cuts in March.
Battle lines forming around appropriate timing of cuts
While a March cut is the consensus view, some disagreement exists around the precise timing for the Fed to halt hikes and transition to rate cuts.
Q1 camp: Analysts in this group argue cooling inflation, slowing growth and market stability give the Fed sufficient room to start cutting rates as early as March. They believe the risks of overtightening and sparking a recession outweigh those of cutting rates too soon.
Q2 camp: Others contend more patience is warranted to allow additional economic data to confirm a sustainable disinflationary trend before the Fed reverses course. This camp sees Q2 as the more prudent timing for the first cut.
The dichotomy sets up a healthy debate around the pace of easing markets can expect. Regardless of precise timing, analysts broadly agree rate cuts are quickly shifting from a possibility to a likelihood in 2023.
Longer-term policy path remains highly uncertain
While markets are laser-focused on potential cuts over the next 2-3 meetings, the longer-term policy path remains highly uncertain and dependent on how inflation dynamics and growth evolve.
Tight labor markets and the prospect of rebounding inflation after reopening from COVID could force the Fed’s hand for more hikes down the road. Conversely, a recession or financial instability could necessitate a return to zero rates.
In the meantime, volatile markets are begging for clear forward guidance from the Fed around what economic developments could prompt pivots between tightening and easing cycles.
Powell has fine line to walk in messaging
Navigating market expectations will be a communications challenge for Powell. He will likely aim to avoid boxing himself in regarding the precise timing of rate cuts while still striking a dovish tone that keeps the door open.
Many feel Powell blundered last year with comments that opened the door for more significant hikes than markets anticipated. He will be careful not to repeat past communication missteps.
Look for Powell to talk down recession concerns while also nodding towards signs of economic slowing. Regardless of specific wording around “cuts,” analysts widely expect a dovish slant from Powell by indicating data dependence and flexibility to adjust policy either way as conditions evolve.
Implications for markets
Markets have shown extreme sensitivity towards Fed policy over the past year. Stocks rallied strongly in recent weeks partly on increased confidence of Fed easing. Any pushback from Powell against market expectations for cuts could spark a retracement.
Likewise, strong signals towards flexibility and data-dependence could provide a boost to risk assets. Still, analysts urge investors to focus more on guidance around economic developments that could prompt policy pivots rather than statements about timing of specific moves.
Bottom line – while the Fed will likely hold rates steady this week, how Powell threads the needle around future policy will have significant market implications in the weeks and months ahead.
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