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Weeks before their final meeting of 2023, Federal Reserve officials appeared to have one goal in mind: maintaining as much flexibility in monetary policy as possible to end what has become an uphill battle to contain inflation.
On Wednesday, Chairman Jay Powell changed tone.
Between a new tone in the policy statement, new forecasts pointing to a less aggressive interest rate path, and Powell’s own comments during a press conference, the signals pointed in a consistently dovish direction.
The shift overshadowed the Federal Reserve’s other, more expected announcement on Wednesday that it would keep interest rates at current levels for the third consecutive day.
Rather, not only did the Fed indicate that its multi-year campaign to tighten monetary policy was now coming to an end, but officials also began to consider deeper cuts in borrowing costs next year – a move that represents a soft landing for the largest economy the world should bring about.
Overall, this brought joy to Wall Street as stocks rose and Treasury yields fell. On Wednesday evening, the yield on the 10-year government bond fell below 4 percent for the first time since August.
Traders in federal funds futures markets increased bets that the central bank could start cutting interest rates as early as March and that rates could end below 4 percent next year, well below their current level of 5.25 to 5.5 Percent. a 22-year high.
But at a time when the inflation outlook is still so uncertain, economists said this is exactly the kind of exuberant outcome the Fed must avoid or risk complicating its own task of fully containing price pressures .
There are fears that looser financing conditions leading to lower capital costs could trigger another wave of borrowing and spending by businesses and households, undoing some of the central bank’s work to curb demand and cool the economy.
“It could go the last mile [of getting inflation down to target] “It will be more difficult because financial conditions will not be as tight as they need to be,” said Vincent Reinhart, who worked at the Fed for more than 20 years and now works at Dreyfus and Mellon.
“Investors are like the kids in the backseat saying, ‘Are we there yet?’ and they’ll just keep saying it [that] at every meeting and their pricing will make the trip longer.”
The main risk for the Fed is that the economy – and its robust labor market – continue to defy expectations of a slowdown, preventing inflation from falling as quickly as officials now expect, said Dean Maki, chief economist at Point72 Asset Management .
“It’s not so obvious that the labor market is currently in line with the Fed’s 2 percent target,” he said, referring to the central bank’s inflation target. “I think there is risk to the strategy at this point in the absence of further inflation or labor market data.”
While monthly job growth has cooled recently, demand for workers in industries ranging from leisure and hospitality to healthcare remains strong. These sectors could sustain a high pace of hiring and consumer spending, Maki said.
Powell flagged those risks on Wednesday, saying it was “premature” to declare victory over inflation and further progress was “not guaranteed.”
But while he reiterated that the central bank could raise interest rates again if necessary, Powell’s warning rang hollow.
One reason was a change in the Fed’s statement specifying the conditions under which it would consider “any” additional tightening.
“We added the word ‘any’ to recognize that we are likely to be at or near peak in this cycle,” Powell said.
That view was supported by forecasts released Wednesday that showed most central bank officials did not expect interest rates to rise further and said they expected deeper cuts next year than in their previous “dot plot” in September published forecasts.
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They now expect the key interest rate to fall by 0.75 percentage points in 2024 and another full percentage point in 2025 before stabilizing between 2.75 percent and 3 percent in 2026.
Powell did not specify what criteria the Fed would use to decide when to begin cutting interest rates, but he indicated that central bankers would take falling inflation into account to ensure interest rates do not remain too high for households and businesses .
The central bank was “very focused” on not waiting too long to cut interest rates, he added.
Wednesday’s shift was made possible by officials’ brighter inflation outlook as well as expectations of slower growth and slightly higher unemployment next year. Powell also said the impact of rising interest rates since March 2022 has not yet been fully felt across the economy.
Michael de Pass, head of linear rates trading at Citadel Securities, said this helps explain why the Fed doesn’t appear to be too concerned about looser financial conditions.
“It seems like they’re taking comfort in the pace of the decline in inflation, taking comfort in the fact that they think the current level of interest rates is quite restrictive, and the fact that there’s still some tightening planned.” “It’s not got through,” he said.