FOMC Preview: Fed to Prepare for a March Cut

Summary

• Since December’s FOMC, growth and inflation have been below or in line with the SEP, with FOMC members expressing a wide range of views on the timing of cuts.
• I expect the statement to prepare markets for a March cut by removing the reference to policy firming and conveying greater confidence that inflation is on a sustainable path to 2%.
• I expect the presser to provide the usual caveats about further hikes if disinflation stops, and about data-driven and meeting by meeting decisions.

Market Implications

• Markets are pricing only about one-third risk of a 25bp cut, while my probabilities are 50% for a 50bp cut, 45% for a 25bp cut, and 5% for no cut.
• This view can be expressed through a SOFR call spread with 6.5x upside if the Federal Reserve (Fed) cuts 50bp in March.

Growth, Inflation Below or in Line With SEP

At December’s FOMC presser, Fed Chair Jerome Powell made a surprise dovish pivot, stating for the first time that the FOMC had discussed rate cuts and taking a sanguine view of the inflation outlook.

The minutes were broadly in line with Powell’s presser. The meeting participants viewed the FFR at or near peak and most expected 2024 cuts. They noted, ‘the decline in inflation seen during 2023, the recent shift down in six-month inflation readings in particular, and the growing signs of demand and supply coming into better balance in product and labor markets.’ The minutes also included the customary caveats about uncertainty and that the Fed would not hesitate to hike again if disinflation stopped.

Since December’s FOMC, growth and inflation have been below or in line with FOMC expectations. The Atlanta Fed Q4 GDP nowcast is 2.4% SAAR, below the SEP projections of 2.6%. Unemployment remains at 3.7%, below the SEP’s 3.8%. Also, the broader labour market indicators the Fed monitors show continued rebalancing (Chart 1). November core PCE has fallen to 3.2% and the December consensus forecast implies Q4/Q4 at 3.2%, in line with the SEP.

Post-December FOMC, six-month core PCE is still falling: it was 1.9% SAAR in November, and the consensus forecast for December implies that it will fall further to 1.8%. This increases the risk that the US could return to the pre-pandemic ‘lowflation’ (i.e., the persistent underperformance of inflation relative to the Fed’s target.

FOMC Views Diverge on Timing of Cuts

In line with Powell’s December presser, FOMC members’ public comments have shifted from ‘it is premature to think about cuts’ to discussing timing of the cuts. They have generally stuck to generic statements, such as ‘the Fed will cut when it is confident inflation is moving back to 2% sustainably’ (Williams, dove, voting), ‘it would be scary to ease too quickly’ (Daly, dove, voting), the Fed should cut ‘methodically and carefully’ (Waller, voter, hawkish), and ‘I don’t want to prejudge the March meeting’ (Barkin, voter, hawk).

The exceptions are Mester (hawk, voting), for whom ‘March is too early’, and Bostic (dove, voting), who is ‘expecting a cut in Q3 from previously Q4’.

In addition, FOMC members are generally attempting to push back against market expectations of multiple cuts, likely responding to easing financial conditions following December’s FOMC (Chart 2). For instance, Logan sees disinflation at risk from easier financial conditions and Goolsbee believes ‘the market may have put the cart before the horse on cuts.’ The exception is Waller, stating that ‘on net, financial conditions remain restrictive and continue to have the desired effect of being a drag on economic activity to put downward pressure on inflation.’

Lastly, FOMC speakers generally see policy in a ‘good place’. However, Waller sees rising risks of overly tight policy, ‘From now on, the setting of policy needs to proceed with more caution to avoid over-tightening.’

Fed to Prepare Markets for a March Cut

I expect the Fed to cut in March due to:

1. High and rising risks of a return to lowflation.
2. Fed resolve to fight lowflation.
3. FFR is 275bp above the long-term dot.
4. Fed’s preference to cut well before elections season is fully underway.

I therefore expect this FOMC meeting to prepare markets for a March cut. Specifically, I expect the following changes to the statement:

• First paragraph: greater stress, possibly through more details, on disinflation progress.
• Second paragraph: unchanged.
• Third paragraph: removal of the reference to ‘policy firming’ and adding a sentence conveying greater confidence that inflation is on a sustainable path to 2%.
• Fourth paragraph: unchanged.

These changes would be consistent with the 2019 Fed game plan: references to hikes were removed in the January 2019 statement, and indications of greater downside risks to the economy were added in the June statement, leading to the July cut. The key differences this time are that inflation is falling much faster than in 2019 and that Fed cuts would be an insurance against lowflation rather than recession.

During the presser, I expect Powell to stick to the messages of the December presser, namely:

• Not concerned by looser financial conditions.
• Sanguine view of the disinflation process, especially wage growth.
• Not concerned by continued GDP growth remaining above potential.

I also expect him to go through all the customary caveats. First and foremost, that Fed decisions will be data driven and taken ‘meeting by meeting based on the totality of the incoming data.’ While I believe that, as explained by Waller, benign February revisions to the CPI are a necessary condition for a March cut, I do not expect Powell to be that specific.

In addition, Powell is likely to warn that the Fed will not hesitate to hike again if disinflation stops, that it will proceed ‘methodically and carefully’, and that it will not cut too quickly, etc.

Market Consequences

Since end-December, markets have lowered their expectations of a 25bp March cut from 90% to about one-third. This likely reflects the strong demand prints together with viewing the cuts as a hedge against recession.

I think Fed cuts would be a hedge against lowflation and I therefore do not see the recent strong demand prints as lowering the risks.

My probabilities for the March meeting remain 50% for a 50bp cut, 45% for a 25bp cut, and 5% for no cut, which is mainly based on the next two core PCE prints lowering six-month core PCE further away from the Fed’s 2% target.

This view can be expressed through a SOFR call spread with 6.5x upside if the Fed cuts 50bp in March.

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.)