The Federal Reserve Pivots to Easing

The Federal Reserve's latest decision suggests that policymakers are encouraged by lower inflation and may pivot to rate cuts in 2024.

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As expected, the Federal Reserve kept the target range for its policy rate—the federal funds rate —unchanged at 5.25% to 5.5% at its latest meeting. The decision was unanimous. While the decision to hold the fed funds rate steady was in line with expectations, the accompanying statement and projections point to a shift toward easing in 2024. In addition, Fed Chair Jerome Powell’s comments in his press conference confirmed that most members of the committee believe that the hiking cycle is over, and they discussed the path to lower rates.

Inflation is the key to the policy pivot

Encouraged by declining inflation, the Federal Open Market Committee (FOMC) signaled that more rate hikes are unlikely in this cycle and that there could be 75 basis points in rate cuts in 2024. The statement that accompanied the Fed’s decision indicated that “growth of economic activity has slowed since the third quarter” and “inflation has eased over the past year.” In the accompanying Summary of Economic Projections (SEP), the median estimate of Fed officials suggests three rate cuts of 25 basis points each in 2024, bringing the fed funds rate to 4.6%. That compares to an estimate of 5.1% as recently as last September.

The shift in the Fed’s projections brings them much closer to what the markets had been expecting compared to its previous projections. The “dot-plot,” which shows each member’s estimates for the fed funds rate going forward for the next several years, indicates much more optimism about inflation heading back to target in the next few years. For a Fed that has been cautious about presenting an aggressive inflation-fighting stance, the change in tone was notable and was reflected in a strong rally in the bond market.

The dot-plot indicates that Fed members expect a significant drop in the fed funds rate over the next few years, returning to 2.5% in the longer run.

Source: Federal Reserve, Summary of Economic Projections, December 13, 2023. The Fed’s quarterly economic projections suggest declining inflation.

Economic projections of Federal Reserve board members

Source: Federal Reserve Board, as of 12/13/2023.

Notes: For each period, the median is the middle projections when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. The central tendency excludes the three highest and three lowest projections for each variable in each year. The range for a variable in a given year includes all participants’ projections, from lowest to highest, for that variable in that year. Longer-run projections for core PCE are not collected. 

The Fed appears on a track to “normalizing” interest rates—moving from a tightening stance to a more neutral stance. At neutral, the Fed hopes to have rates at a level consistent with slowing growth and inflation at 2%.

Since the last FOMC meeting, the benchmark inflation measure that the Fed uses—the deflator for personal consumption expenditures excluding food and energy (core PCE) has declined. It has trended steadily lower over the past year and now stands at just 3.5% compared to a peak level of 5.6% in this cycle. That progress appears to be encouraging the Fed to begin rate cuts sooner rather than later.

Inflation has trended steadily lower.

Source: Bloomberg, monthly data as of 10/31/2023.

The personal consumption expenditures (PCE) index measures the changing prices of goods and services. “Core” PCE excludes food and energy prices, which tend to be volatile. For PCE: Personal Consumption Expenditures Price Index (PCE DEFY Index), For core PCE: Personal Consumption Expenditures: All Items Less Food & Energy (PCE CYOY Index), percent change, year over year.

If the Fed left policy unchanged for a long time period as inflation declined, then real interest rates—adjusted for inflation—would continue to climb, exerting more pressure on economic growth. Real interest rates are already at the highest levels since 2008. Therefore, to some extent, Fed rate cuts are just aimed at preventing real interest rates from rising to even higher levels, risking a recession.

Real yields are at the highest levels since 2008.

Source: Bloomberg. US Generic Govt TII 2 Yr (USGGT02Y INDEX), US Generic Govt TII 5 Yr (USGGT5Y Index), US Generic Govt TII 10 Yr (USGGT10Y Index).  Daily data as of 12/13/2023.

Treasury Inflation-Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. They can be used as an indicator of real, or inflation-adjusted, yields. Past performance is no guarantee of future results.

The Fed’s economic projections indicate that the committee expects a modest rise in the unemployment rate, but not in the range that would suggest a recession forecast. Fed Chair Powell suggested in his press conference that the labor market is “coming back into balance.” Given the Fed’s mandate to aim for full employment along with low inflation, this is the “soft landing” scenario that the central bank has been seeking.

Quantitative tightening continues

The prospect of lower short-term interest rates is positive for the economic outlook and financial markets. However, the Fed does plan to continue to reduce the size of its balance sheet by allowing bonds it holds to mature without reinvesting the principal. The balance sheet has already fallen by more than $1 trillion from its peak. Continuing with quantitative tightening “in the background” may prove more difficult long-term if the economy slows down more than anticipated. However, for now, the reduction plan seems to be working without disrupting financial markets.

Financial markets responded positively to the surprisingly “dovish” projections from the Fed. Markets often make big moves at turning points. With rate cuts now on the horizon, yields of all maturities should continue to trend lower as the Fed looks to get to a more “neutral” interest rate, Two-year Treasury yields are nearly 80 basis points off the cyclical highs while ten-year treasury yields are nearing 4% after having touched 5% in late October. In the near term, the market reaction may be somewhat overdone, and we do expect volatility ahead, but we continue to be optimistic about the prospects for returns to fixed income investors in 2024. 

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Charles Schwab & Co., Inc. (“Schwab”) and TD Ameritrade, Inc., members SIPC are separate but affiliated subsidiaries of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank.

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