Fed Signals Hawkish Stance Despite Rate Cut

The financial landscape is currently marked by persistent inflation rates that exceed the targeted thresholds, set against a backdrop of robust economic growth estimated at around 3%. Amidst a resilient labor market, these factors would typically suggest a conducive environment for the Federal Reserve to consider increasing interest rates, or at the very least, keeping them stableHowever, the upcoming policy announcement from the Federal Open Market Committee (FOMC) could present a different narrative.

Interestingly, futures market traders are nearly unanimously anticipating a reduction in interest rates, predicting a cut of 25 basis points, which would adjust the target range down to between 4.25% and 4.5%. Such a move could potentially be seen as an effort to navigate the economic terrain more delicately.

Despite the overwhelming market sentiment in favor of a rate cut—93% of survey respondents expect one—there’s a substantial degree of trepidation regarding whether this is truly the correct path

Only 63% of the same respondents indicated that lowering rates is the advisable course of actionThis discrepancy highlights a growing sense of caution among financial experts and economists.

For instance, prior to the anticipated decision, former Kansas City Fed president Esther George expressed her skepticism regarding a rate cut in a recent interviewShe articulated a preference to maintain rates, suggesting, “Let's wait and see how the data unfoldsA cut of 25 basis points typically wouldn’t shift our current situation, but I believe now is the time to send a message to the market and the public that we are not overlooking the issue of inflation.” This sentiment underscores the delicate balancing act facing the Fed as they weigh economic stability against the real threat of inflation.

Indeed, inflation remains a central concern for policymakersAlthough annual inflation rates have receded significantly from the forty-year highs reached in mid-2022, projections suggest that throughout much of 2024, inflation may linger between 2.5% and 3%. The Federal Reserve, in contrast, has established a clear inflation target at 2%, which intensifies the challenge of justifying a policy pivot.

In an important announcement anticipated from the Commerce Department, the Fed's preferred inflation measure—the Personal Consumption Expenditures (PCE) price index—is slated to show an uptick to 2.5% in November, with core inflation, which excludes food and energy costs, hitting 2.9%. This anticipated data release adds further complexity to the Fed’s decision-making process.

In light of this milieu, it will be incumbent upon Federal Reserve Chairman Jerome Powell and his committee to adeptly communicate the rationale for any decision to lower rates

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George opined that, “They are well aware of their objectives, and with the inflation data cropping up, we see a failure to continue the previous trend of declining inflationHence, I believe there’s a valid reason to exercise caution and seriously contemplate how much relaxation of policy is necessary to reinvigorate the economy.” This caution is noteworthy, especially as it reflects the broader unease regarding the implications of monetary policy adjustments on both inflation and employment rates.

Interestingly, some Fed officials supportive of a rate cut argue that the current environment does not necessitate overly stringent policies, voicing concerns over potential ramifications for the labor marketTheir sentiment reflects a dual commitment: one to alleviate the inflationary pressure while simultaneously safeguarding job growth and economic vitality.

The notion of “hawkish easing,” that is, a strategy that suggests readiness to reduce rates while simultaneously signalling caution about future cuts, underscores the complexity of the current economic climate

Should the Fed go ahead with a rate reduction, it will represent a total decline in the federal funds rate by a full percentage point since September.

While this may offer a significant relief in the short term, the Fed possesses several instruments at its disposal to convey that further cuts are not imminentOne such instrument is the dot plot matrix, a graphical representation that reflects the individual members' projections for future interest rates over the next few yearsThis matrix will be updated alongside the Summary of Economic Projections on Wednesday, shedding light on expectations around inflation, unemployment, and GDP growth.

Another strategy involves utilizing the post-meeting statement to provide guidance on the committee's outlook regarding policy directionFinally, Powell’s press conference will offer yet another venue for providing further insights, as market participants will be closely scrutinizing his dialogue with the press

Recent assertions from Powell have indicated that in the context of a “strong” economy, the Fed is in a position to “consider a more measured pace” regarding policy loosening.

Economists, such as the Chief Economist at Bank of New York Mellon and former Director of Monetary Affairs at the Fed, indicated an expectation that there will be a slight upward adjustment in inflation forecastsReinhart remarked, “We can anticipate a trend toward action where inflation expectations are adjusted upwardThe dot plot will inch upward slightly, and an overall hawkish sentiment regarding reductions is likely to surface.”

As we look ahead, many on Wall Street foresee that the Federal Reserve Board will raise its inflation expectations for 2025 while simultaneously tempering its outlook on the timing of rate cutsThese adjustments are crucial as they reflect the overarching strategy to balance growth with inflation control.

During the last update of the dot plot in September, Fed officials hinted at a potential reduction of 100 basis points over the next year

However, based on the CME Group’s FedWatch tool, the market has since dialed down expectations for further easing, predicting only two rate cuts in 2025 following this week's anticipated decision.

Moreover, the Fed might consider forgoing the January meetingAnalysts speculate that the subsequent public statement may not warrant significant changesThis expectation is compounded by the likelihood that officials might also raise their projections for the “neutral” rate—the interest level that neither stimulates nor hampers economic growthTraditionally hovering around 2.5%, this neutral rate has shown a gradual upward trend in recent months and could hover above 3% in the forthcoming updates.

Finally, given that the federal funds rate sits near the lower bound of its target range, an increase in the overnight reverse repurchase agreement (RRP) rate by 5 basis points is plausible