The positive economic data this week appears to have given the markets the green light for the Federal Reserve to begin aggressively lowering interest rates next year.
Traders went into a frenzy when they saw signs that the rates of consumer and wholesale inflation had significantly decreased from their peaks in mid-2022. The most recent data on the CME Group’s Fed Watch gauge indicated a full percentage point of reductions by the end of 2024.
That might be overly optimistic, especially in light of the cautious stance that central bank officials have adopted in their attempt to lower prices.
Wrightson ICAP’s chief economist, Lou Crandall, stated, “The case isn’t made conclusively yet.” “We’re moving in that direction, but we haven’t reached a point where they will declare that there is no longer a risk of leveling out at a level that is excessively above target.”
Two significant Labor Department reports were released this week: one revealed that overall consumer prices remained unchanged in October, while the other showed that wholesale prices fell by 0.5 percent in the same month.
The consumer price index remained at 3.2% even though the producer price index dropped to 1.3% over the course of a year. Additionally, the core CPI continues to run at a 4% 12-month rate. Furthermore, inflation continued to rise at a 4.9% annual rate according to the Atlanta Fed’s measure of “sticky” prices, which are those that don’t fluctuate as frequently as things like gas, groceries, and car prices.
We’re drawing nearer, Crandall declared. “The information that we have received this week is in line with what you would hope to see as you proceed in that direction. However, we haven’t yet arrived at our destination.
Looking for inflation of 2%
The “destination” for the Fed is an inflation rate that is “convincingly” approaching its 2% annual target but not quite there.
We made the decision to keep the policy rate in place while we awaited more information. During his September news conference following the meeting, Federal Reserve Chair Jerome Powell stated, “We really want to see convincing evidence that we have reached the appropriate level.”
The 12-month core CPI has decreased every month since April, though Fed officials haven’t said how many consecutive months of declining inflation data it will take to get to that conclusion. As a more accurate indicator of long-term inflation trends, the Fed favors core inflation measures.
Right now, traders seem more confident than Fed officials.
Pricing for futures Based on the CME Group’s gauge of pricing in the fed funds futures market, which was released on Wednesday, there appears to be little chance of further hikes this cycle. The first quarter percentage point cut is scheduled for May, followed by another in July, and probably two more before the end of 2024.
If accurate, that would double the rate of increase that Fed officials penciled in back in September and bring the benchmark rate down to a target range of 4.25%–4.5%.
The markets will thus be particularly interested in seeing how officials respond at their upcoming policy meeting on December 12–13. The meeting will include a rate call in addition to quarterly updates to the officials’ “dot plot” of expected interest rates and forecasts for inflation, unemployment, and the gross domestic product.
However, the pricing of Fed moves can be erratic, and before that meeting, there are two more inflation reports. Wall Street may be let down by the Fed’s assessment of the short-term policy direction.
Former Boston Fed President Eric Rosengren stated on “Squawk Box” on Wednesday that “they’re not going to want to signal that now is the time to start talking about decreases in interest rates, even if fed funds futures already has that incorporated.”
‘Soft landing’ observations
This week’s market excitement was based on two main tenets: the expectation that the Fed will soon begin reducing interest rates and the realization of the much-discussed “soft landing” that the central bank intended for the economy.
Nonetheless, it is challenging to reconcile the two points given that historically, such aggressive monetary policy easing has only coincided with economic downturns. In addition, it appears that Fed officials are reluctant to become overly dovish. Chicago Fed President Austan Goolsbee stated on Tuesday that he sees “a way to go” before hitting the inflation target while simultaneously leaving open the possibility of a “golden path” that would prevent a recession.
According to Rosengren, “a slower economy rather than a recession is the most likely outcome.” “However, I think there are undoubtedly negative risks.”
For a Fed seeking to tighten financial conditions, the recent decline in Treasury yields combined with the stock market rally presents another obstacle.
According to Quincy Krosby, chief global strategist at LPL Financial, “financial conditions have eased considerably as markets project the end of Fed rate hikes, perhaps not the perfect underpinning for a Fed that professes to keeping rates higher for longer.”
Indeed, even from those members who have stated they oppose further hikes, the higher-for-longer tenet has been a pillar of recent Fed discourse.
It’s a part of a larger sentiment at the central bank that it doesn’t want to make the same mistakes as in the past and give up the battle against inflation as soon as the economy begins to falter, as it has done recently. For example, October saw a decline in consumer spending for the first time since March.
It’s a challenging calculation for Fed officials, who are reluctant to admit they are overconfident that the last mile is in sight.
According to economist Crandall, who began working at Wrightson ICAP in 1982, “this illusion of control is part of the problem the Fed always has to deal with.” “They have the ability to affect things, but not control them. The intricacies of the contemporary global economy are fueled by far too many external factors. I therefore have a moderate amount of optimism [that the Fed can meet its inflation targets]. That and being confident are slightly different.
