Fed Readies for Rate Cuts: Back Toward Neutral, or Mid-Cycle Adjustment?

U.S. Federal Reserve Chair Jerome Powell’s confident press conference following the March meeting coupled with revised Fed projections suggest Fed officials are determined to cut interest rates this year – most likely starting in June. Fed officials signaled that it would take a dramatic turn of events to knock them off this course. The median interest rate forecast for 2024 did not change from three 25-basis-point (bp) rate cuts by the end of 2024, despite upward revisions to the inflation forecasts.

We believe the very modest upward adjustment in the expected path of interest rates past 2024, despite a strong U.S. economy and recent stickier inflation readings, suggests that the Fed views the competing risks (recession versus persistent inflation) as reasonably balanced now. So if core PCE inflation (personal consumption expenditures, the Fed’s preferred measure) remains within the “2-point-something” zone – not far above the 2% target – when Fed officials meet in June, we expect they will cut.

Bumps in the road, or embedded stickiness?

While our baseline is that U.S. core PCE inflation should moderate to 2.5% in the second quarter after accelerating above 3% in the first quarter, we continue to expect PCE to remain above-target absent additional labor market easing.

Chair Powell dismissed the reacceleration in core PCE as part of a bumpy path toward lower inflation. However, we’re concerned that still above-target wages, the reacceleration in the core services ex shelter measure, sticky rental inflation, and fading tailwinds from lower goods prices all mean that getting inflation sustainably back to 2% may take more time – and require a weaker economy.

Underscoring how much the Fed’s reaction function around inflation risks has shifted, Fed officials’ median core PCE inflation forecasts are the same in March 2024 as they were in September 2023, yet the Fed is now projecting an interest rate path for 2024 that is 50 bps lower.

How determined is too determined?

The Fed’s strong guidance toward cutting relatively soon has us focused on a new question: Will the rate cuts be the beginning of a prolonged series, or will sticky inflation and potentially easier financial conditions risk turning the upcoming rate cuts into a mid-cycle adjustment, as opposed to a smooth path back toward neutral? Signs of persistent or higher inflation could still derail the steady series of cuts indicated in the Fed’s latest projections.

One concern is that the market reaction to the initial rate cut could result in more easing in financial conditions than the Fed wants. Communication will be crucial – the Fed may emphasize it could slow, or stop, its rate-cut cycle in an effort to tighten conditions and better control inflation. Or the Fed could decide to tolerate 2-point-something inflation for an extended period rather than risk stifling economic activity too much. It’s a balancing act.

Balance sheet changes ‘fairly soon’

Chair Powell also announced that after Fed officials discussed the balance sheet at the March meeting, they are ready to make an announcement “fairly soon” on what we have been calling a “taper and extend” policy. Officials may announce in the next meeting or two that they are lowering the caps on Treasury runoff from the Fed balance sheet. Getting this decision out of the way before they turn to interest rate cuts argues for a May meeting announcement.

So far, the quantitative tightening (QT) program hasn’t tightened liquidity conditions in the traditional sense – reserves are higher than when the Fed started the program. Money market rates are not trading as if reserves are shrinking from “abundant” down to “ample” or even scarce (borrowing terms Chair Powell emphasized in his press conference). The likely plan is to hold reserves steady once they drop to ample levels, just before the point of scarcity.

The Fed will likely continue to reduce the size of its asset holdings through 2024, and likely into 2025. Overall, we expect this strategy will achieve reserve levels of around $3.5 trillion by year-end, and closer to $3.0 trillion by year-end 2025.

(For details, see our 31 January 2024 Macro Signposts, “The Fed’s Balance Sheet Reduction: Outlook, Market Implications, and Potential Strategies.”)

Longer-term considerations

In the March economic projections, the median estimate for the long-run policy rate (a proxy for Fed officials’ view of neutral policy that neither hinders nor stimulates growth) edged higher, to 2.6% from 2.5%. The distribution of views among individual participants also generally shifted higher.

We believe the gradual drift higher in individual neutral estimates over the past year may continue, but we don’t expect the longer-run median to shift meaningfully higher for now. We think questions about the longer-run neutral level – and whether the resilience of the U.S. economy through this period of high interest rates is an indication of structural economic changes – would be answered in the Fed’s 2025 policy framework review.