FOMC Review: Fed Sees Disinflation Glass Half Full

Summary

• As I expected, the Federal Reserve (Fed) stuck to its narrative of continued but slower disinflation and kept three cuts in 2024.
• Fed Chair Jerome Powell also made it clear the Fed would not attempt to cap growth to accelerate disinflation.
• Powell also indicated a quantitative tightening (QT) taper was likely to start soon.
• Overall, I have greater conviction of a June cut and of three 2024 cuts as the Fed turned out more dovish than I expected.

Market Implications

• I agree with the market pricing a 75% chance of a cut by June and of about three cuts by end-2024.

Fed Sticks to Its Narrative

As I expected, the Fed kept its narrative of continued but slower disinflation. Powell said ‘the overall story of inflation moving down gradually on a sometime bumpy road towards 2% had not changed.’

He saw the high January CPI and PCE prints as mainly reflecting seasonality. He stated that, just like the Fed had not overreacted to the fast disinflation of 2023, it was not going to overreact to the January bump. He also indicated that the Fed estimate of February MoM core PCE was ‘well below 0.3%.’

As I expected, the median 2024 dot was unchanged at 4.6%. The average 2024 dot increased to 4.8% from 4.7% and the range of forecasts narrowed (Chart 1). The median 2025 and 2026 dots were raised 25bp each and the long-term dot 10bp. Powell stressed that, while ‘his instinct was that rates will not go back to the very low levels prevailing pre-pandemic’, he ‘didn’t think we know.’

Fed to Let Positive Supply Shocks Run Their Course

Powell also made it clear the Fed intends to let the positive supply shock hitting the US economy – the combination of fast growth with disinflation – fully run its course.

This is shown by the increase in 2024 growth and inflation forecasts by 0.7% and 0.2% to 2.1% and 2.6%, respectively, while keeping the median 2024 dot unchanged. Also, 2026 remained the year when inflation returns to target.

Furthermore, Powell made it clear he was comfortable with higher growth while remaining committed to returning inflation to target ‘over time.’ For employment, as long as labour demand and labour supply continued to come into better balance, he was comfortable with strong employment prints.

Ultimately, the Fed has no intention to sacrifice growth to return inflation to target faster.

QT Taper Discussion Started

As announced before the meeting, the FOMC has started its QT taper discussion. Powell stated ‘it will be appropriate to slow the pace of the balance sheet runoff fairly soon.’ He  indicated that current discussions are about the pace of the runoff and that by going slower the Fed could shrink its balance sheet further because it would enable a ‘smoother transition’ and ‘reduce the risks of a liquidity shock.’

Powell further indicated that the Fed would consider a broad range of money market indicators to decide when reserves were becoming ample, from currently abundant. The plan was to stop shrinking the securities portfolio and let non-reserve liabilities (e.g., currency) grow organically and shrink reserves at a slower pace.

Stronger Conviction on First Cut in June

When asked when he would have enough confidence to cut rates, Powell replied with his stock-in-trade formula of taking decisions meeting by meeting and that he needed to become more confident that disinflation is continuing.

That said, this FOMC has increased my confidence that the first cut is likely in June:

• The 2024 forecast showing higher growth and inflation together with an unchanged dot shows the Fed is more dovish than I expected.
• The bar to clear for the three 2024 rate cuts is low. Core PCE was 2.8% in January, only 20bp above the Fed’s new end-2024 target. In practice, the Fed is likely to cut as long as inflation hovers around 2.8% or below.
• Powell is not concerned by easier financial conditions. He believes financial conditions are ‘weighing on economic activity’ and explain the labour market cooling.
• With its hyper data dependency and perception of unusual economic uncertainty, the Fed wants to proceed cautiously (i.e., cut every other meeting). If so, cutting three times in 2024 will require the Fed to get started in June.
• Emerging financial imbalances could motivate the Fed to cut sooner rather than later.

And as Powell indicated, unexpected labour market weakening would bring forward the cuts but like Powell this is not my base case scenario.

Longer term, I think the combination of disinflation and strong growth is unsustainable, but this is a 2025 story.

Market Consequences

I agree with the market pricing a 75% chance of a cut by June and of about three cuts by end-2024.

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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.

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(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.)