What Will the Fed Do Next?

On December 13th, the Federal Reserve maintained the fed funds rate for the third consecutive meeting.

The Statement

While much of the released statement remained unchanged, it was the subtle inclusion of one word that suggested an imminent conclusion to this tightening cycle.

The Summary of Economic Projections (SEPs)

More importantly, the SEPs compiled by the Fed Board members and Presidents underwent its usual quarterly update. The most notable adjustment was a 50-basis point drop in the 2024 projected Fed funds rate, which now stands at 4.6%. The new rate implies a cumulative 75 basis points in rate cuts during 2024. The projected Fed funds rate for 2025 was also revised downward by 30 basis points to 3.6%, implying the possibility of another four cuts in 2025. The dot plot of participants’ expectations for future target rates continues to illustrate a wide dispersion among 2024 rate projections with the lowest estimate at 4% and the highest estimate held steady at 5.5%. In fact, one member even estimates a 5.5% target rate in 2025, suggesting either zero rate cuts or an expeditious cycle of rate cuts followed by a return to a tightening stance.

Also of note, within the SEPs there was a 20 basis point drop in 2024 core PCE, a 10 basis point drop in 2024 real Gross Domestic Product (GDP) growth, and a 10 basis point rise to 4.1% in the longer run unemployment rate. The drop in projected PCE came as no surprise, as inflation indicators leading up to the meeting have shown signs of continued disinflation.

The Presser

Throughout the press conference, Powell faced questions regarding the Fed’s outlook on the pace of potential rate cuts.  While our expectations may have been conditioned over the past year to expect Powell to swiftly deflect such questions, he surprisingly responded without hesitation. The traditional Fed motto of “higher for longer” may very well be evolving into a stance of “alright that’s long enough.” While the market still expects the Fed will be forced to implement faster cuts than the SEPs suggest, it is becoming clear that the Fed is now focused on the risks of keeping rates too high for too long. When pressed about the abrupt shift in mindsets, Powell iterated “This inflation was not the classic demand overload, pot-boiling over kind of inflation that we think about. It was a combination of very strong demand, without question, and unusual supply-side restrictions, both on the goods side but also on the labor side, because we had a [labor force] participation shock.”

Time for the usual check-up…

Economy

In the latter part of last month, the third-quarter GDP saw a positive adjustment, revised upward by 30 basis points to +5.2%. This upward revision extended to various components, including increased capital expenditure growth, elevated government spending, enhanced inventories, and boosted residential investment. These revisions more than compensated for a slight downward adjustment in consumer spending. Despite the positive surprise in the third-quarter revisions, it’s essential to note that they represent trailing indicators. Markets have largely accepted that the economy is beginning to slow, with the magnitude of that slowdown being top of mind.

November brought an unexpected turn in retail sales, registering a growth of +0.3%, surpassing expectations following a -0.2% decline in October. Even more impressive, excluding autos and gasoline, sales grew +0.6%. While singular data points should be considered cautiously, strong retail sales in the face of declining inflation supports the idea of a soft landing.

Inflation

As expected, the Consumer Price Index (CPI) increased 0.1% in November, putting the index 3.1% above where it was a year ago. Excluding the more volatile food and energy prices, core CPI increased 0.3% in November, leaving the index 4% higher compared to the same period last year. Shelter prices, which make up roughly one-third of the CPI, recorded a monthly increase of0.4%, but showed a continued decline from its early 2023 peak to +6.5% on an annual basis. Expectations of moderating inflation are being further perpetuated by the continued decline in crude oil prices, with WTI Crude briefly dipping below $70 earlier this month. Efforts by OPEC+ to deepen production cuts are effectively being neutralized by slower Chinese demand and rising U.S. production. All in all, the decline in gasoline and heating oil prices is expected to positively impact the consumer, both psychologically and in terms of real spending.

In November, wholesale prices remained unchanged, as the Producer Price Index (PPI) exhibited a flat performance following a -0.4% decrease in October. The PPI, often considered a leading indicator of inflation, reflects the potential pass-through of wholesale pricing to the consumer.

Given these favorable inflationary signals, the preliminary December University of Michigan Consumer Sentiment Index (MCSI) came in at 69.4 compared to the estimated 61.6 and November’s 61.3. Both the current conditions and expectations component rose proportionately as the one-year inflation expectations declined to 3.1% from 4.5% in November – the lowest level since March of 2021.

Job Market

Weekly jobless claims remain below this year’s June peak but have begun to test their 100-day moving average. November nonfarm payrolls showed job growth of 199k – well above the 175k estimate and helped by the end of the United Auto Workers (UAW) strike, giving back 28k of the previously lost jobs. While the November payrolls were strong, both the October and September numbers underwent downward revisions totaling 35k. The unemployment rate surprisingly declined to 3.7% from 3.9%, reversing half of the 40-basis point increased observed over the preceding four months. Average hourly earnings rose +0.4%, slightly above the +0.3% expectation and the +0.2% reported in October. Also of note, labor force participation rose 10bps in November back to the post-pandemic high of 62.8%. October’s Job Openings and Labor Turnover Survey (JOLTS) showed an 8.6% decline, marking its lowest level since March of 2021. The trend of lower job openings should lead to lower wage inflation, which is exactly what the Fed wants to see.

So, What’s Next?

Future markets indicate the pace of expected rate cuts should amount to 150 basis points by the end of 2024, which notably exceeds the more conservative projections outlined in the Fed’s SEPs. There is a wide range of opinions among Fed members on what path and pace inflation will take. As uncertain as people were about the pace of rate hikes, they are about the pace of rate cuts. What we can take solace in is that a soft landing now looks to be more likely as the Fed projections show they expect to be able to cut rates next year while GDP is still growing.

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