Deciphering the Fed

As expected, the Federal Open Market Committee (FOMC) kept rates on hold at its meeting on 20th March and reiterated the same message that Chair Powell and various other Fed officials have repeated over the past few months:

(i) Good progress has been made on inflation
(ii) The labour market is in better balance
(iii) The FOMC wants to see a bit more progress on inflation before easing policy
(iv) The FOMC expects to cut rates later this year; contingent on the data

The infamous dot-plots were little changed from the previous release in December 2023. The median FOMC member expects to cut rates three times this year and another three times in 2025. Futures markets are now aligned with the Fed in terms of expectations for this year although it has been a volatile journey.

Last October futures were pricing the probability of a March 2024 rate cut at around 15%. By late December 2023 that had risen to as high as 90% before declining sharpy to only a little above 0% by late February, where it stayed until the March FOMC meeting. Similarly, whereas in December 2023 futures were pricing nearly seven rate cuts in 2024, only three rate cuts are now expected. See Chart 1.

Chart 1. Probability of a March 2024 rate cut and year end rates

Source: Bloomberg, EFG calculations. Data as at 20-Mar-24.

Unsurprisingly, changes in rate expectations have been closely associated with shifts in perceptions about the path of inflation. Stronger-than-expected CPI data for December, January and February has been a particular catalyst for expectations of tighter policy, bolstered by continued strong nonfarm payrolls data and other labour market indicators.

Inflation and labour market data are important for the Fed’s mandate, which is in two parts. According to the Federal Reserve Act, the Fed should set monetary policy to achieve: (i) stable prices (ii) maximum employment¹. “Stable prices” are defined as the rate of inflation FOMC members expect to see in the “longer run” in their projections for PCE inflation, which is 2% per annum. The concept of “maximum employment” is not explicitly defined. In making that judgement the Fed “considers a broad range of labour market indicators, including how many workers are unemployed, underemployed, or discouraged and have stopped looking for a job”². With the unemployment rate having been below 4% for more than two years, it is hard to argue that the labour market is anything other than tight.

Table 1 summarises the two dimensions of the Fed’s decision-making process and presents a simplified way to think about the direction of monetary policy.

Table 1. A simplified decision matrix for the Fed

Source: EFG. 18-Mar-24.

If inflation is above target and labour markets are tight, as indicated by a low unemployment rate, then the Fed’s decision is easy: it should hike (top left corner). This is the situation that occurred in 2022 when it became apparent that high inflation was not transitory. Similarly, if inflation is below target while the unemployment rate is relatively high then the Fed can comfortably afford to ease policy (bottom right corner). However, much of the time the policy environment is more nuanced.

If, for example, inflation is above target but in a declining trend and the labour market is stable or perhaps moderately deteriorating, the decision regarding whether to change policy is not so straightforward. This is a good description of where we are today. Core inflation has declined sharply from the peak but is above target and has increased recently. At the same time, the unemployment rate is close to recent lows and other measures of the labour market also point to tight conditions. The Fed’s reticence to cut rates therefore makes sense in this context. Furthermore, given the uncertainty in forecasting inflation and unemployment, it is easier for the Fed to leave rates unchanged and wait-and-see than risk making a policy mistake by cutting prematurely, something that would damage credibility if it had to be reversed shortly afterwards.

The Fed’s process is in practice much more complicated than looking at a simple matrix. The FOMC must take into account a multitude of factors that influence the outlook for inflation and the labour market as well as incorporating a view on the likely leads and lags in the system, which are famously variable. The Fed is therefore trying to simultaneously assess: (i) current conditions (ii) the lagged impact of past decisions and (iii) the future path of key variables. This is hard to do.

Nonetheless, it is useful to consult this simple – some may say obvious – matrix to consider objectively where we are today and what are the implications for the policy outlook. Doing so allows us to identify the most likely policy outcome and look through the noise that can be evident in markets, such as we have seen in terms of the wild swings in futures pricing over the past few months.

In conclusion, if the US labour market stays tight and inflation remains persistently above target then the Fed is unlikely to cut, regardless of what is priced into futures. Moreover, it is possible that this situation endures for longer than markets currently anticipate. If economic activity holds up well while inflation drifts back only slowly towards target then expectations regarding the timing of the first rate cut may need to be pushed out later into the year. Assessing incoming data against the matrix in this report will inform that judgement call.

¹ There is technically a third element to the Fed’s mandate, which is to promote “moderate long-term interest rates” although the first two elements dominate the Fed’s monetary policy actions and market expectations of them.
² See https://go.pardot.com/e/931253/its-goals-how-does-it-work-htm/41dht/344618217/h/Zfy5MG1OMTyuPIFYkKrxOIzWUm-GXxDiOM2rWcmiXjU