Federal interest rate cut? The strong US economy makes decision making risky

Strong growth in the United States looks set to reinforce Federal Reserve officials' belief that they can bide their time cutting interest rates, as they prepare to meet on Wednesday.

The Federal Open Market Committee will almost certainly vote to leave benchmark interest rates unchanged at their highest level in 23 years of 5.25 to 5.5 percent, after a long effort to tame rampant inflation.

However, the question remains about the extent to which Fed Chairman Jay Powell hints at cuts on the horizon. About half of investors are currently pricing in the move at the next Fed meeting in March, but many economists are instead pointing to late spring or early summer.

The concern among interest rate setters is that a premature cut could lead to a return of price pressures. Those betting on a subsequent move say the US economy is healthy enough to enable the Fed to mitigate these risks by keeping interest rates higher for longer.

Gross domestic product grew at an annual rate of 3.3 percent in the fourth quarter, marking a strong end to a year in which many economists thought the United States would fall into recession.

The growth rate for the year as a whole was 3.1 percent, the best performance of any major advanced economy.

“There is nothing in the data since the beginning of the year that suggests the economy is in danger,” said Krishna Guha, a former Fed official who now works at Evercore ISI.

“If you're a policymaker, you have a lot of choices about when to go. Starting later plays into this desire to confirm that everything is on track to return inflation permanently to 2 percent.”

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Last month, Fed Governor Christopher Waller said he was confident the central bank was within striking distance of meeting its 2 percent inflation target, after a sharp decline in price pressures in the second half of 2023.

However, he said strong growth and a tight labor market meant officials would not have to act hastily. “I don't see any reason to move as quickly or reduce as quickly as in the past,” Waller said.

Seth Carpenter, an economist at Morgan Stanley who believes the first cut will come in June, said the varying bets on the timing of the cuts reflect widely differing views on the outlook for the US economy.

“Some people still think there will be a recession in 2024,” Carpenter said. “Others believe inflation is now completely under control.”

“We expect a soft landing, but we are not in a completely different situation from the markets,” he added. “If we are wrong in June, I expect it will be because the cuts will be earlier, rather than later, than our baseline.”

Fed watchers believe that, barring economic catastrophe, interest rate setters will want to signal before a meeting that cuts are on the way.

“I expect that if they are planning for March, we will get a very clear hint of that from Powell in January,” said Guha, who expects May or June to be the most likely timing for the first cut.

However, some say it will be difficult for Powell to give a strong signal for such a move this week, given that headline inflation in the US rose from 3.1 per cent in November to 3.4 per cent last month.

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But the measure the Fed closely monitors, core personal consumption expenditures inflation, fell to an annual rate of 2.9 percent in December.

The Fed chair may also be reluctant to definitively rule out a cut on March 20, as two more sets of nonfarm payrolls data, the leading indicator of the health of the US labor market, are scheduled to be published in the meantime.

The January PCE inflation report and two sets of headline inflation numbers are also expected before the March meeting, as well as data revisions that reveal the extent to which seasonal adjustments will impact December's rise.

“Data flow is going to be extremely important,” Carpenter said.

Another issue on the table at the Fed meeting is whether quantitative tightening should be slowed. The US central bank currently manages up to $60 billion in US Treasury securities and $35 billion in other government securities each month.

However, minutes from the December meeting indicated that some members felt that the frequency of QT needed to be reviewed soon.

They said the sharp decline in the use of money market funds to facilitate central bank buying and selling of Treasuries could mark the beginning of the end of a period of abundant liquidity.

Since then, Lori Logan, president of the Dallas Fed and former head of the markets team at the New York Fed, has noted that a slower pace of QT could reduce the chances of a rise in funding costs.

She said avoiding those jumps would enable the Fed to continue shrinking its balance sheet uninterrupted for a longer period.

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Sharp rises in funding costs during previous episodes of QT in 2019 will push officials to make a decision sooner rather than later, said Nate Wuerfel, former head of domestic markets at the Federal Reserve Bank of New York and now at Bank of New York Mellon.

“There is the idea of ​​slowing down and then stopping [the run-off of assets] “Very early in the decline of reserves from abundant levels to abundant levels,” Wuerfel said.

“Policymakers are talking about this because some of them have really deep memories of the 2019 experience and want to give the banking system time to adjust to lower reserve levels.

“They know that there are limits to what data can tell us about how financial markets behave.”

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