What Powell's pivot means for markets

At the December Federal Open Market Committee (FOMC) meeting, the benchmark policy rate remained at 5.25%-5.50% for the third consecutive meeting, which was in line with expectations. More significantly, the latest dot plot revealed the committee expects 75 basis points of cuts next year—essentially endorsing the market’s view that the direction of travel for rates is downwards.

Countdown to rate cuts

In recent weeks, several Fed speakers have suggested a shift to a more dovish stance. As a result, coming into today’s meeting, the market was pricing in 115 basis points of cuts next year, with the first cut expected as soon as March.

There had been a broad expectation that today’s FOMC meeting would see a pushback against such dovish market expectations. Yet, Chair Powell emphasized the significant inflation progress to date, noting that rate cuts were a topic of discussion by the FOMC today, and the latest dot plot revealed a sharper pace of rate cuts than indicated in the September projections. Markets are now pricing in 130 basis points of cuts next year.

Updates to the Summary of Economic Projections

The new dot plot and Summary of Economic Projections indicated that inflation has decelerated significantly, a soft landing is highly likely, and the need to maintain policy rates higher for longer has diminished:

• The median projection sees rates falling to 4.6% by the end of next year. This equates to 75 basis points of cuts in 2024, 25 basis points more than in the September dot plot—a clear dovish shift. However, the December dot plot still sees 50 basis points of cuts fewer than markets are currently pricing.
• There was a fairly wide range of estimates, with eight participants anticipating fewer than three rate reductions next year, but five participants were expecting deeper cuts.
• The median dot falls further to 3.6% by end-2025, equivalent to another 100 basis points of cuts. By contrast, the September projection had 125 basis points of cuts.
• The median dot then falls to 2.875% in 2026 (unchanged from September)—still above the median longer-run dot, which remains unchanged at 2.5%.

The Summary of Economic Projections also showed some meaningful revisions:

• The core PCE inflation forecast for 2023 was revised down from 3.7% to 3.2%, suggesting that inflation progress is more significant than initially anticipated. The 2024 forecast was downwardly revised from 2.6% to 2.4%, with inflation then progressively fading and finally hitting the Fed’s 2% target in 2026. This improved inflation forecast has likely driven the decision to add an additional 25 basis points of easing next year.
• Recognizing the significantly stronger 3Q performance, the 2023 GDP forecast was upwardly revised from 2.1% to 2.6%. However, growth then slows to 1.4% next year (versus 1.5% in the September projection).
• A significant pickup in unemployment does not accompany the economic slowdown in 2024. The 2024 unemployment rate projection was unchanged at 4.1%, suggesting only a mild 0.3% increase through next year. Furthermore, the unemployment rate does not increase in the following two years. The Fed clearly feels some confidence in achieving a soft landing without significant job losses.

These latest inflation and rate projections are not too dissimilar to our own:

• We see GDP growth of 2.7% this year (essentially the same as the FOMC), and a more significant slowdown next year than the Fed envisions—although we also expect recession to be avoided. We project a rise in the unemployment rate to 4.5% by end-2024 (versus 4.1% for the Fed).
• On the inflation front, our forecast sees headline CPI dropping to around 2.5% by the end of 2024—the Fed sees headline PCE inflation falling to 2.4%.
• For rates, our forecast is also for 75 basis points of cuts in 2024, with the first rate cut coming in June.

Outlook

Today, Powell stopped short of declaring the tightening cycle over, making a cursory nod to the idea that the committee will consider the extent of “any” additional firming if needed. Yet it is abundantly clear that the rate hiking cycle is over, and the next move will be downwards.

Markets appear to have been encouraged by Powell’s rather lackluster pushback at current rate pricing and have further raised their bets that rate cuts will begin early in 2024. However, while a policy pivot looks increasingly likely next year, it is unlikely to materialize until economic growth has visibly slowed, the labor market has softened, and there has been a run of soft inflation prints. By mid-year, these characteristics of a slowing economy should be lined up, finally clearing the path to the first Fed rate cut of the cycle.