Cutting short-term interest rates from a peak is a little like hauling a piano down a flight of stairs. The operation is best done slowly and with care.
The Federal Reserve will probably show some awareness of this in their actions and communications this week. That being said, one of the greatest identifiable dangers to the economy and markets today is that the Fed, by acting too aggressively or talking too negatively, increases the risk of the economy falling into recession.
Our base case view is that they will avoid this. We expect the Fed to cut the federal funds rate by 25 basis points, rather than 50, and, in doing so, highlight their satisfaction with progress on inflation rather than any worries they might have about economic growth.
Their messaging will be conveyed in their Summary of Economic Projections, the FOMC statement, Chairman Powell’s Press Conference and their “dot plot” which outlines their expectations for the future path of short-term interest rates.
The Summary of Economic Projections
While the FOMC holds eight meetings per year, it only releases a summary of economic projections four times. Consequently, this Wednesday’s forecasts will update projections from the middle of June.
On economic growth, we expect little change. While members of the committee may foresee some economic weakness between now and the end of the year, the reality is that real GDP growth was 3.1% year-over-year in the second quarter and the Atlanta Fed GDPNow model is forecasting 2.5% annualized growth in the third. Our own forecasts are a little softer, as we see real GDP rising by 2.0% annualized in the third quarter and less than 1.0% annualized in the fourth, as both consumer spending and investment spending shift down a gear. However, this should still leave growth at close to 2.0% year-over-year by the fourth quarter of 2024, very close to the 2.1% projected by the FOMC in June.
Moreover, with good gains in real wages and wealth, as well as lower long-term interest rates, it appears the economy is quite capable of sustaining this 2.0% pace through 2025 – exactly in line with the June SEP.
On unemployment, we expect the committee to project 4.2% unemployment by the fourth quarter of this year, slightly higher than the 4.0% they forecast in June. The unemployment rate rounded to 4.0% in May, the last release before the June SEP while today it stands at 4.2%. However, we do not expect the committee to project any significant rise in the unemployment rate in 2025 or beyond. Chairman Powell has made it clear that he doesn’t wish the unemployment rate to move higher from here and, given the FOMC’s collective confidence in the efficacy of monetary policy, it is unlikely that they will project failure in achieving this key policy goal.
On inflation, the FOMC forecasts should look more optimistic than three months ago. In June, they expected year-over-year headline PCE inflation to be at 2.6% in the fourth quarter of this year and 2.3% at the end of next. However, given August CPI data and falling gasoline prices in September, the FOMC could shave at least 0.2% from each of those numbers.
The Statement and the Press Conference
For many years, FOMC participants have played a sort of word game with their statement, in which they try to express any change in their outlook by altering the fewest words possible. Clearly, if they cut rates as we expect, they will have to engage in a greater-than-normal degree of editing. Nevertheless, in characterizing the economy, they can still afford to be parsimonious.
In particular, they will likely want to sound a little more positive on inflation than saying, as they did in their last statement, that “Inflation has eased over the past year but remains somewhat elevated”. Perhaps they could change it to “Inflation has eased significantly over the past year but remains slightly elevated”.
They will also likely modify or remove the sentence from their last statement in which they asserted that “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
There really is no need to downgrade their assessment of economic growth or the labor market in the FOMC statement, but they still might feel tempted to do so. Such a downgrade would unnecessarily chip away at consumer and business confidence, although presumably only to a slight extent.
The danger of unduly negative messaging will be more significant in the Chairman’s press conference. Since the July FOMC meeting, the Bureau of Labor Statistics has announced a significant downward revision to employment in March 2024 as part of its annual rebenchmarking process. In addition, the July and August jobs reports showed a slower pace of payroll job growth than was apparent earlier in the year.
Chairman Powell typically speaks at length on the state of the jobs market, both in his opening statement and in his back and forth with reporters. He must, of course, acknowledge this slowdown in job growth. However, the extent to which he sounds confident that this is just a “normalization” of the job market, rather than something more sinister, will likely be pivotal to how the markets react on Wednesday.
The Dot Plot
The other key issue is the dot plot, which displays the opinions of FOMC participants on the outlook for the federal funds rate. Currently, the federal funds rate stands in a range of 5.25% to 5.50% and, in June, the median FOMC participant expected just one 25 basis point rate cut in 2024 and four more in 2025. They also professed to believe that, in the long run, the federal funds rate should be close to 2.8%.
We expect, given changes in the data and their economic projections, that the median forecast on Wednesday will show two rate cuts in 2024 and four in 2025. It is also possible that they will adjust their estimate of the long-run neutral rate upwards to 3.0%.
If they do this, it will clearly be a challenge to the futures market which is currently pricing in more than 100 basis points of cuts over the next four months and 250 basis points in cuts between now and the start of 2026.
It may well be that the futures market is not providing an unbiased view of the future. It could be simply reflecting a bi-modal set of potential outcomes, with a soft landing as the most likely scenario but a significant risk of something worse which would trigger much more aggressive easing from the Fed. Or it could be that projected interest rates in the fed funds futures market are being dragged down by a very strong bid for medium and long-term Treasuries as investors continually try to rebalance portfolios which have become heavily overweight equities.
Whatever the reason, both the bond market and the fed funds futures market may price in higher long-term interest rates and less aggressive Fed easing if the Fed’s actions, projections and messaging are as we hope and expect them to be on Wednesday.
For investors, this should be a good outcome since a soft landing scenario is clearly positive for financial markets. However, investors should still make sure they are well diversified as a Fed that over-reacts in its actions or which sounds too alarmist in its views could well upset the confidence that is so important to the economy and financial assets.