Fed holds rates in December but hints at deeper rate cuts in 2024

14 Dec 2023 , 10:45 AM

Fed holds rates, but hints at a more dovish approach

When Jerome Powell made his statement on December 13, 2023, it did appear like the CEM Fedwatch was finally having its way. In the last few weeks, the CME Fedwatch had substantially diverged from the Fed viewpoint. In the past, whenever such a divergence had been observed, it was the CME Fedwatch that had eventually reconciled to get in sync with the Fed viewpoint. However, this time it was tad different. For the first time, the Fed indicated at 3 rate cuts of 25 bps each in 2024, as against the earlier indication of only 2 rate cuts in 2024. Also, the Fed underlined that it would not hesitate to hike rates if the inflation situation so demanded, but the markets hardly giving any heed to such warnings any longer. If you go by the reaction of the US bond yields and the Dow Jones index, it looked like celebration time all along. So, what exactly was different about this Fed statement.

Says Jerome Powell – Hey, this time it is different 

The legendary Sir John Templeton had once warned investors that the 4 most dangerous words in the investment lexicon were “This time it’s different”. Of course, Templeton was referring to the markets, but that could as well apply to the macroeconomy. Here is how the Fed statement in December was starkly different from previous statements. 

• For the first time, the Fed statement did not overly challenge the CME Fedwatch indications but actually increased the dovishness of its tone. They had reasons for this change. PCE inflation is already at 3% and US GDP growth for Q3 was robust at 5.2%. With the risks of hard landing out of the way, there is really not much to worry.

   

• From hinting at a best case scenario of 2 likely rate cuts in 2024, the Fed has shifted to 3 rate cuts in 2024 that were almost certain. That has given the markets reason to believe that more rate cuts could be on the way in 2024, which induced the CME Fedwatch to stretch itself further in the dovish direction.

   

• Unlike previous occasions, the Fed in its December statement has not made the rate cuts contingent upon low inflation or soft landing of the economy. It has gone to the extent of hinting that rate cuts need not be contingent with a soft landing and sharply lower inflation rate. That almost makes minimum of 3 rate cuts a fait accompli in 2024.

   

• The dot plot also provides a longer term perspective. The Fed has now hinted at 3 rate cuts of 25 bps each in 2024 and another 4 rate cuts of 25 bps each by end of 2025. However, the CME Fedwatch is pencilling in six to seven rate cuts in year 2024 itself. Fed may differ, but the direction provided is clearly along dovish lines.

   

• For the first time, the Fed chair admitted that the US economy was either close to peak rates or already at peak rates. While rate hikes were always the ace up the sleeve that the Fed had maintained, this is the first time that the Fed has let its guard down. It has accepted that rate hikes will happen only if there negative surprises on inflation front.

   

• The Fed also suggested that the US economy had surprise the Fed in terms of its resilience and growth momentum. While Q4 will not be as robust as Q3, the Fed is now pencilling in GDP growth rates of over 2.5% in 2023. That is sharply higher than the original estimate of 1% and the revised estimate of 2% GDP growth in 2023.

Reactions to the Fed statement have been mixed. While the markets generally welcomed the Fed tilt towards dovishness, there are concerns that the Fed may have led its guard down too much and too soon. Some like Brad Conger of Hirtle Callaghan have even warned that history may not be kind to Powell and the Fed, if inflation were to rear its head again. For now, we just need to wait and watch the outcomes.

CME Fedwatch is veering towards too much dovishness

One way to look at the Fed outlook from a market perspective is the CME Fedwatch, which captures probabilities of rate levels after each Fed meet over next 1 year.

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Jan-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	19.6%	80.4%
Mar-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	16.3%	70.0%	13.7%
May-24	Nil	Nil	Nil	Nil	Nil	Nil	15.2%	66.5	17.4%	0.9
Jun-24	Nil	Nil	Nil	Nil	1.0%	18.7%	63.2%	16.3%	0.8%	Nil
Jul-24	Nil	Nil	Nil	1.0%	17.5%	58.2%	21.0%	2.3%	0.1%	Nil
Sep-24	Nil	Nil	0.9%	15.7%	53.7%	25.1%	4.3%	0.3%	Nil	Nil
Nov-24	Nil	0.6%	11.0%	41.6%	34.2%	10.9%	1.6%	0.1%	Nil	Nil
Dec-24	0.5%	8.6%	34.7%	36.5%	16.1%	3.6%	0.4%	Nil	Nil	Nil

Data source: CME Fedwatch

Will this go down as the case where the CME Fedwatch prevailed over the Fed, when it came to the dichotomy of opinions. It may be too early to say, but clearly the CME Fedwatch is veering sharply towards a lot of front-ending of rate cuts too. The CME Fedwatch now expects the rate cuts to begin as early as the upcoming January 2024 Fed policy. That is not all. The CME Fedwatch also anticipates (if you look at the probabilities) that there could be 7 rate cuts of 25 bps each in the eight Federal Reserve meetings scheduled in 2024. That is almost like saying that the Fed will cut rates in virtually each of the Fed meetings in 2024.

So, here is the dichotomy. The Fed has hinted that there would be 3 rate cuts of 25 bps each by the end of 2024 which will take the Fed rates from the range of 5.25%-5.50% to the lower range of 4.50%-4.75%. However, the CME Fedwatch has pencilled in a very high probability that the Fed rates would fall a full 175 basis points from  5.25%-5.50% to the lower range of 3.50%-3.75%. In short, what the Fed has been guiding as rate cuts in 2024 and 2025 combined, the CME Fedwatch expects that to be entirely front-ended in 2024 itself.

What we read from the December Fed statement

Markets were expecting the Fed chair, Jerome Powell, to make a more affirmative statement on the road ahead and that is exactly what he did. The statement was almost an admission that the Fed was done with hawkishness and would veer towards cutting rates from 2024 onwards.

1. In its December 2023 meeting, the US Fed held key interest rate steady for the third time in a row. In fact, the Fed has maintained a status quo in 4 out of the last 5 Fed meetings, a clear enough signal that the Fed was done with rate hikes for now. However, this time around, the Federal Open Markets Committee (FOMC) went a step further and pencilled in 3 rate cuts of 25 bps each in year 2024 and another 4 rate cuts in the year 2025; taking it to a total of 7 rate cuts in next two years of 175 bps by end of 2025.

    

2. While there was little doubt that the Fed would maintain its status quo, the markets were split on the language of the Fed. With rates at 22-year  highs for a fairly long time, the Fed through it fit to soother frayed nerves in the market by making a shift away from its avowed hawkish policy. As the Fed chair, Jerome Powell, admitted; there was really no need for the Fed to stay so hawkish when inflation and growth were all at comfortable levels. 

    

3. While the Fed may not have explicitly stated the same, there is a possibility that the Fed may be preparing for a new normal on inflation, which is higher than inflation readings in the past. What it means is that the Fed may not stay too rigid on the 2% target. It is possible that it may be comfortable letting its hawkish guard down as long as the inflation was in a relatively subdued range of 2.5% to 3.0%. However, we do not have any such confirmation from the Fed, although a new higher normal for consumer inflation has been adequately spoken about in market circles.

    

4. One of the words used for the first time in recent Fed statements was that the committed would use “multiple factors” to decided on the need and logic of future rate hikes. In the past, it was largely about inflation, but this is probably the first shift that future Fed policies will not be about inflation and price stability alone; but also, about factors like GDP, credit tightness, labour market etc.

    

5. One more important aspect of the Fed action in the last year and half has been the consistent unwinding of $95 billion of bonds each month by now rolling over the proceeds from maturing bonds. This has already compressed the Fed balance sheet from $9.1 trillion to around $7.6 trillion, which actually magnifies the impact of rate hikes. One argument that has been thrown around, even within Fed members, is that if you add the impact of this balance sheet unwinding, then the actual effective rate cuts would be much more than the 550 bps we all get to see. 

    

6. One thing is clear from the Fed statement that the Fed does not expect the core inflation to come down to 2% any time soon. In fact, if one looks at the dot plot, the most like time frame by which the core inflation could get back to the 2% mark is either the end of 2025 or the middle of 2026. What the Fed is now betting on is that with the perceptible fall in inflation, the glide path of inflation is decisively down. That is an important shift in the December Fed policy statement. 

    

7. The Fed has stopped using the term “hard landing” any longer. That is not surprising considering the resilience that GDP growth has shown. In fact, if you look at the dot plot, then the GDP is expected to grow at 2.6% for 2023, that is a good 50 bps higher than the revised estimate of GDP growth and a good 150 bps above the original Fed estimate of GDP growth. Fed clearly believes that soft landing has been well and truly achieved.

    

8. One of the big impact that stubbornly high prices in the US economy have had  is on the approval ratings of Joe Biden, which have suffered due to the way he handled the US economy. There is speculation that the Fed may be averse to any dramatic policy action during a presidential election year in 2024. 

One thing that could work against too Fed hawkishness, is the real rate of interest which is around 250 bps (gap between repo rates and inflation rate). Such high rates have impacted the cost of funds for American borrowers and that, at the end of the day, has made all the difference to the stance of the Fed. 

What does the Fed statement mean for the RBI?

RBI had effected its last rate hike in February and has kept rates on hold over the next 5 MPC meetings in April, June, August, October, and December 2023. The good news for the RBI is that the consumer inflation, despite the bump up on November to 5.5%. That does away with any immediate risks to inflation, especially considering that core inflation is sharply lower than it was a few months back. Will robust GDP and core sector, the RBI has less to really worry about on the growth front.

With the RBI holding status quo on rates since February 2023, it almost looks like rate hikes are done and dusted. The latest December Fed minute would only reinforce this view. In December, the Fed has not just held rates but also made a distinctly dovish shift. Whether that induces the RBI to also change its monetary stance and start talking about rate cuts in coming policy, remains to be seen.