FOMC Review: Fed Likely to Cut in December

Summary

• The FOMC cut 25bp as expected.
• Powell expressed his confidence in a soft landing and willingness to accept inflation above target for another couple of years.
• The Fed is likely to cut 25bp in December as core PCE is likely to remain in its comfort zone.

Market Implications

• I agree with markets pricing about 70% chance of a 25bp cut in December.

Fed Cuts 25bp as Expected

As expected the Fed cut 25bp. The statement was tweaked but during the presser Powell clarified that the changes did not convey a change of forward guidance but rather updated the statement to reflects that the conditions for a cut spelled out in September had already been met.

Powell Remains Confident in Soft landing

Powell remained confident in the soft landing: “we’re not declaring victory, but we feel like the story is very consistent with inflation continuing to come down on a bumpy path over the next couple of years and settling around 2 percent. That story is intact, and one or two really good months or bad days and months aren’t going to really change the pattern at this point now that we’re this far into the process.“

Powell said it was too early to tell how the incoming administration policies would impact the Fed as “we don’t know what the timing and substance of any policy changes will be.” He stressed that the Fed was taking fiscal policy as given and not commenting on the specifics. He further stated that even if asked by President-elect Trump, he had no intention of resigning and that removing him was “not permitted under the law”.

Questions were both dovish and hawkish. In response to dovish questions on the impact of tighter financial conditions, Powell felt that the higher Treasury yields were not a risk to growth and that, while the Fed was watching financial conditions, they hadn’t changed meaningfully enough for a long enough period of time to impact Fed policy.

In response to hawkish questions on why the Fed was cutting when growth was strong and inflation above target, Powell replied that the Fed wanted to bring its policy stance closer to neutral, though he didn’t know at this stage where neutral would end up. He also stated that the Fed “did not see the labor market as a source of inflationary pressures” and did not want it to soften from here.

December Cut Likely

There were a number of attempts, direct and indirect, to get Powell to reveal his plans for December, which he of course fended off. He stated that the December decision would be based on the employment report and two inflation reports “and lots of other data” that would become available before the December meeting. He described September inflation as “not terrible but a little higher than expected”.

This suggests a further 25bp cut in December is likely. As Powell stated the Fed is happy to have inflation remain above target, which I think means hovering in a 2.5-3% band, for the next two years. I believe Powell hopes to go back to the 2% target through opportunistic disinflation over the next couple of years.

So the Fed could cut 25bp in December provided core PCE prints below 25bp in October-November that would translate into Q4/Q4 core PCE below 2.9%. This is my base case as inflation tends to move slowly and the 3m and 6m averages have been respectively 22bp and 19bp.

If core PCE turns out above but close to 25bp, the Fed is likely to get concerned and look at broader macro data, especially labour market conditions, for confirmation of disinflation trends. The Fed is likely to focus on unemployment and wage growth, i.e., indicators of the balance between labour demand and supply, rather than employment, due to the uncertainty surrounding unrecorded immigration.

PCE clearly above 25bp on average during October-November could see the Fed pause in December.

Unemployment above the SEP 4.4% could see the Fed cut 50bp, provided core PCE remained under 25bp. This does not seem likely as unemployment is currently 4.1% and growth is running above potential: the Atlanta Fed Q3 GDP nowcast was 2.5% on 7 November.

Market Consequences

The Fed move was well anticipated, and market reaction was limited. As of this writing (1AM GMT) the implied December FFR is about 1bp lower, 2yr and 10yr yields unchanged relative to before the FOMC.

The market is pricing about 70% chance of a December cut, roughly in line with my degree of conviction.

(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.)