Don't expect a Fed cut in March

At the January Federal Open Market Committee (FOMC) meeting, the benchmark policy rate remained at 5.25%-5.50% for the fourth consecutive meeting, which was in line with expectations. Fed Chair Jerome Powell offered two important messages today:

• Rate hikes have most likely come to an end.
• Rate cuts are unlikely to come in March.

What they need to commence rate cuts

Powell noted that if the economy evolves broadly as expected (inflation continuing to decelerate further and economic activity moving closer towards trend growth), then it will be “appropriate to begin dialing back policy restraint at some point this year.”

While this admission will not have surprised anyone, the FOMC’s requirement that they gain “greater confidence that inflation is moving sustainably towards 2%” before cutting rates likely confounded many market participants. After all, with core PCE already trending around 2% at the six-month and three-month annualized levels, what exactly does the Fed require to gain greater confidence? Does this imply that they need additional months showing core PCE at 2%, or will they only feel comfortable once there is clear evidence of slower economic growth?

Unsurprisingly, those questions dominated the press conference. Powell offered only slightly more color and very little clarity.

On inflation, he said they do have confidence that inflation is trending towards 2% but need “greater” confidence. Although the Fed already has six months of inflation data indicating that inflation is heading to 2%, Powell noted that they need “more.” Unfortunately, no clarity was given on how Powell defines “more.” Still, he did emphasize that much of the improvement in inflation to date has come from core goods inflation, so now the improvement needs to come from services inflation.

On the economy, Powell noted three rather different ideas. 1) They do not view strong growth or a strong labor market as an obstacle to inflation falling further. 2) The key risk from strong growth is that inflation stabilizes at a level above 2%, not that it resurges again. 3) Unexpected labor weakness could bring forward the rate cutting timeline.

Finally, after having tussled with those concepts for a while, Chair Powell explicitly noted, “I don’t think it’s likely that the committee will reach a level of confidence by the time of the March meeting.” Unless the labor market deteriorates suddenly or sharply, a March cut is essentially off the table.

Side note: Fed balance sheet

In recent weeks, several FOMC members have commented on the need to consider slowing the pace of balance sheet run-off (quantitative tightening). Addressing this, Powell said that while policymakers have begun discussing the topic, they plan to have a deeper discussion at the next meeting.

Policy outlook

Our view has been that, given the continued strength of economic data and the risk that it poses to the inflation outlook, March is too soon for the first rate cut—May or June are more likely.

In addition, the market expects the Fed to cut rates five to six times this year (down from seven to eight a few weeks ago). Historically, however, the Fed has only reduced rates so aggressively when it was confronted by recession. While we expect economic growth to lose momentum, we do not anticipate recession. And while we expect the labor market to soften, we do not expect the unemployment rate to spike. With the Fed likely to proceed more gradually and with greater caution, we expect only three to four rate cuts this year. They will look to keep real rates fairly constant as inflation continues to approach the 2% target.