FOMC Preview: December Cut, Targeting Rangebound Inflation

Summary

• The Fed is likely to cut next week despite disinflation stalling as it believes policy is still restrictive and risks to the mandate are balanced.
• The SEP is likely to show two 2025 cuts next year due to:
  • Recently slower progress on inflation.
  • Risks of higher R*.
  • Uncertainty on the incoming Donald Trump administration.

Market Implications

• I expect a 25bp cut next week in line with markets and no cuts in 2025 against markets pricing about 2.5 cuts.

Unemployment, Inflation Roughly Aligns With SEP

At the 4 December Q&A, Jerome Powell did not push back against market pricing a December cut. Since the Fed dislikes surprising markets, this suggests a cut next week, provided inflation data remains within recent ranges, my base case. In this note, I explain why and discuss the forthcoming SEP.

Economic developments have roughly aligned with the September SEP, implying a December cut (Table 1).

October PCE aligned with the SEP and core PCE YoY was only 20bp above the SEP Q4/Q4 forecast. If November and December core PCE print at the 3m average of 23bp, Q4/Q4 core PCE would print at 2.9%, still within the Fed’s comfort zone (June SEP showed 2024 core PCE at 2.8%). The greater inflation concern is that the core PCE trajectory has flattened (Chart 1).

Unemployment roughly aligns with the SEP and is up from the low of 3.4% in Q1 2023, but this was unsustainable. By historical standards, unemployment at 4.2% is low (see NFP review).

By contrast, GDP growth remains well above the FOMC 2024 and long-term estimates of 2% and 1.8% respectively. The disconnect between growth and labour market performance reflects the ongoing productivity surge (Chart 2). The productivity surge implies that, even though wage growth remains higher than before the pandemic, Unit Labor Costs (= wage growth minus labour productivity) are consistent with 2% inflation.

All FOMC members still think inflation is returning to 2%. Also, in his 14 November speech, Powell repeated the Fed saw balanced risks to the inflation and employment legs of its mandate. Dissenters to this view are Bowman (voter, hawk), who sees greater risks to the inflation mandate and to a lesser extent Musalem (non-voter, hawk) who sees greater risks of easing too fast than too slow (Table 2). No FOMC member has recently stated risks to employment are greater than to inflation.

Fed Still Sees Restrictive Policy

FOMC members agree the policy stance is restrictive but how much? Based on the difference between FFR and September’s long-term dot, the Fed still has ample room to cut. The difference between Taylor rule and the actual FFR, about 70bp, also suggests room to cut. My version of the Taylor rule has been a reasonable predictor of Fed policy this cycle: the Fed went on hold after crossing the Taylor rule.

Financial conditions, which the Fed sees as transmitting the policy stance, also suggest room to cut (Chart 5). The Fed’s own indices see financial conditions as detracting from growth (Fed FCIs are expressed in growth impulse over the subsequent year).

Meanwhile, the Fed is aware of limits to financial conditions indices. First, they tend to change much faster than economic conditions. As Powell has often stated, the Fed considers financial conditions ‘if they are persistent and material.’ Second, the Fed stresses growth and financial conditions are jointly determined. Hence, the FCI ‘should be interpreted as providing a rule-of-thumb approximation of the effects of observed, and possibly endogenous, changes in financial variables on future GDP growth.’ Finally, the Fed stresses its FCI ‘does not fully capture the broader set of relationships between financial variables and economic activity.’

In addition, the Fed’s FCI is limited at predicting inflation largely because translating the one year ahead growth impulse into inflation ‘requires a structural model and non-trivial assumptions about the relationship between these variables.’ Rather than point estimates, the Fed prefers assessing FCI impact on the distribution of inflation. A simple plot of the Fed FCI against core PCE shows no obvious relationship (Chart 6).

Fed to Cut 25bp Next Week

A cut next week will therefore reflect the FOMC unanimously thinking inflation is still returning to 2% and most FOMC members still see balanced risks to inflation and employment. Against this economic backdrop, the FOMC still views the policy stance as restrictive. Even though FOMC members are concerned R* could be higher than before the pandemic, the FFR is still far enough from their estimate of R* to allow a cut.

The SEP is less straightforward.

Two 2025 Cuts

I reckon three factors will drive the next week SEP.

First, FOMC members agree they must have more details on Trump 2.0 policies before deciding how these will impact the policy outlook, though they will discuss several scenarios.

Second, FOMC members agree the pace of cuts should slow, which aligns with the recent flattening of the inflation trajectory FFR (Chart 7).

Third, the Fed medium-term inflation strategy is likely to be opportunistic. Powell sees inflation almost at target, ‘Nonhousing services and goods, which together make up 80 percent of the core PCE index, are back to the levels they were at the last time we had sustained 2 percent inflation, in the early 2000s.’ Housing Inflation is higher, but Powell sees this as ‘just a catch-up problem.’

Powell intends to allow goods and non-housing services inflation ‘to fluctuate in their recent ranges’ and will be ‘watching carefully to be sure that they do’ just as he will be ‘closely tracking the gradual decline in housing services inflation, which has yet to fully normalize.’

In other words, the Fed will not allow core PCE to rise above its current range of about 2.5-3% and will not cut until disinflation resumes. This suggests an asymmetric reaction to inflationary and disinflationary shocks.

Also, the Fed must communicate a soft landing. Not doing so would convey a lack of confidence in its ability to control inflation. So, the SEP could show (Table 3):

• Higher core PCE in 2024-25 but an unchanged return to target in 2026.
• Higher long-term FFR aligned with FOMC members comments on the risks of a higher R* and with GDP growth resiliency.
• Only two cuts in 2025 aligned with FOMC members comments that the pace of cuts must slow and the likely higher long-term dot.
• 2024 growth and unemployment to reflect the latest data.
• Roughly unchanged trajectory for 2025-27 growth and unemployment.

Finally, I expect quantitative tightening (QT) to continue. There are signs of tightening money market liquidity but the Fed has decided to address them through lowering the RRP rate rather than through ending QT (Charts 9 and 10). With a negative spread between assets and liabilities, the Fed would rather have a smaller balance sheet.

Market Consequences

My expectations for a 25bp cut next week aligns with market pricing.

I still expect no 2025 cuts largely because I do not think the pickup in productivity growth will be large and persistent enough to offset the slower growth in labour supply and therefore in potential output (Chart 10). This is against markets pricing about 2.5 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.)