December 2023 FOMC Review: Fed Turns More Confident

Summary

• The Federal Reserve (Fed) was more dovish than I expected, as faster-than-expected disinflation and higher unemployment have increased its confidence that its policy stance is tight enough.
• Fulfilling the Summary of Economic Projections (SEP) conditions for the three 2024 cuts included in the SEP would require inflation to remain below the average of the past six months through 2024.

Market Implications

• Markets are pricing the first cut by March and six by December, which implies either that inflation goes back to target next year or that the economy goes into recession.
• I still expect that inflation is troughing, which is not consistent with Fed cuts.

Fed Turns More Confident on Policy Stance

The Fed’s guidance turned out more dovish than I expected:

• The Fed communicated a lower risk of further hikes in the statement and the presser while not ruling them out entirely. Fed Chair Jerome Powell conveyed less certainty that demand compression would be needed to bring inflation back to 2% and more certainty that the unwinding of COVID-19 pandemic imbalances alone would be enough.
• Contrary to his 1 December guidance that, ‘it was premature to speculate when policy might ease’, Powell mentioned that rate cuts had been discussed at the meeting but did not provide details on what could trigger them. This is not actually a big change in guidance since cuts were already included in the September SEP and therefore are likely to have been discussed at that meeting.
• The SEP soft-landing scenario and policy reaction function were unchanged. The SEP continued to show a return to the 2% target by 2026 with virtually no change to the growth and unemployment trajectories. The 2023 core PCE forecast was lowered by 50bp and the 2024 forecast by 20bp. The number of 2024 cuts was raised by one and the 2025 cuts lowered by one.

This likely is a reaction to the recent inflation slowdown as well as to unemployment moving off the post-pandemic lows of 3.4%, i.e. the Fed is more confident that its soft-landing scenario is proceeding apace (Chart 1).

Powell also indicated that the Fed was less focused on short-term changes in financial conditions as he expected them to eventually fall in line ‘with what we are trying to accomplish.’

Fed to ‘Proceed Carefully’

Powell did not provide details on what could trigger a cut. He repeated during the presser that the Fed would ‘proceed carefully’ and that it needed more evidence to be convinced that inflation was on a sustainable path to 2%. He further added that the Fed would not look at inflation only but at the totality of the data, including growth and wages that ‘are still running a bit above what would be consistent with 2% inflation.’

I still think that the Fed cutting more/less than pencilled in the SEP depends on actual core PCE relative to the SEP benchmarks. The Fed skipped the last 2023 FFR hike because actual inflation fell short of the September SEP benchmark. The additional cut in 2024 was added as the FOMC expected faster 2024 disinflation than in September.

Core PCE at 2.4% Q4/Q4, the condition for the three 2024 cuts, would require average monthly inflation of 0.2% until end-2024, which is the average of the past six months (Chart 2). Monthly core inflation only 5bp higher, i.e. 25bp/month would be enough to keep Q4/Q4 2024 core PCE at 3%, which would preclude cuts.

How soon would the Fed cut after a string of low inflation prints? In my view, this would depend on unemployment. Should unemployment remain at the currently low level of 3.7%, the Fed would require a longer string, for instance, six consistently low prints. This is because the tight labour market would leave a risk of inflation resurgence.

By contrast a string of 20bp or below prints with rising unemployment could see the Fed react faster, for instance, it could cut after three to four prints. This is because the Fed would be more confident that its soft-landing scenario is actually happening.

These are all hypothetical to me as I do not believe that the low prints of the past six months are sustainable.

Market Consequences

Following the Fed meeting, the market is now pricing one full cut by March, three by June and six by December. The only way I can make sense of this would be if the US was about to enter a recession.

If not, Fed cuts are likely to depend on actual inflation relative to the SEP benchmark: six cuts by end-year would imply Q4/Q4 core already at 2% and in a sustainable manner! A cut by March appears equally unlikely as not enough data would be available for the Fed to be proceeding carefully.

Today’s FOMC did not give me new information that would change my view on inflation and therefore I am not expecting the Fed to cut this year.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(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.)