FOMC Preview: A Wait and See Hold

Summary

• The Fed will likely hold rates steady next week as inflation and growth remain stable and high.
• It will have too little information on the Trump administration’s economic program to assess the impact on policy.

Market Implications

• I still expect no cut in 2025 against markets pricing about 1.5 cuts.

Stable and High Inflation and Growth

Markets are pricing almost zero chance of a cut next week, which aligns with recent FOMC communications (Table 1). Here, I explain why and discuss the key issues likely to emerge at next week’s FOMC meeting.

At the December FOMC, Chair Jerome Powell explained that with the Federal Funds Rate (FFR) now close enough to its neutral value, further FFR cuts required actual disinflation progress.

Since then, inflation, growth and employment have been stronger than implied by the December Summary of Economic Projections (SEP) and stable (Table 1).

Based on CPI and PPI, we expect December core PCE to print 20bp MoM, equal to the three- and six-month averages. This is unlikely to change the Fed’s inflation view as it shows limited disinflation progress (Chart 1 and Inflation Monitor).

The details also do not support further policy easing. While slowing, housing inflation remains volatile (Chart 2). And supercore inflation, the main driver of core inflation, remains high and stable, aligning with wage growth. Meanwhile, goods price deflation seems to be ending (Charts 3 and 4).

More recently, Powell and Governor Christopher Waller have stressed that market-based core PCE was slowing faster than core PCE, with inputed non-market services ‘largely driving 2024 inflation’ according to Waller (Charts 5 and 6). However, they need more data to be confident the slowdown in market-based inflation will continue.

Aligning with high and stable inflation, since the December FOMC, growth has remained well above trend and the labour market tight (Charts 7 and 8; see Labour Market Monitor).

Fed Sees Policy Less Restrictive

As Powell has stressed, following 100bp cuts in 2024, the FFR is now closer to R* so that the Fed must be more cautious with further easing. Powell does not believe models can provide real time accurate estimates of R* but rather that the evolution of the economy and inflation will signal how tight policy still is.

Powell’s caution seems warranted as indicators of policy tightness are sending conflicting signals. The FFR is now roughly equal to my very simple Taylor rule that suggests the Fed is unlikely to cut until either inflation decreases or unemployment rises (Chart 9). This would be consistent with the Fed pausing in 2023 after the FFR crossed the Taylor rule.

Yet the FFR is still well above the long-term dot (Chart 10). This could reflect that the long-term dot underestimates R*, as shown by the gap between long-term dot and the market’s long-term real rate (Chart 11).

While the Fed financial conditions indices (FCIs) show financial conditions detracting from growth, this is not consistent with above trend growth and a tight labour market (Chart 12).

Because no rate cut is in play this time, the conflicting signals do not matter much. However, they could eventually prove more important.

Fed on Hold Next Week

A key issue for the economic and therefore Fed outlook is the economic policy of the incoming administration. Too much uncertainty persists for the Fed to build consensus over their impact.

For instance, while it is clear some tariffs will be imposed, it is unclear when, how much and whether they will be generalized or specific (see webinar). Similarly, it is clear the TCJA tax cuts will be extended but it is unclear yet whether there will be additional tax cuts and whether those will be paid for.

I expect many of the uncertainties to be resolved by the 19 March FOMC meeting as Congress is aiming to have a budget by May. This implies the key budget parameters (spending, revenues, tariffs, etc.) should be known by end-February.

I therefore expect Powell to refrain from commenting on the Trump administration’s economic plans, to acknowledge the latest OK-ish inflation print but otherwise repeat that actual disinflation is required for further Fed cuts. The presser could see the Macro Hive Fed LLM Sentiment Index rise as three of the four latest speakers (Cook, Kugler and Waller) have been more dovish than Powell (Chart 11).

Lastly, I expect quantitative tightening (QT) to continue. Signs exist of tightening money market liquidity but the Fed has decided to address them through lowering the RRP rate rather than through ending QT (Charts 11 and 12). Furthermore, the debt ceiling has become binding, which will empty the Treasury General Account into banks’ reserves.

Market Consequences

I still expect no cut in 2025 against market expectations of about 1.5 cuts.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)