The Federal Reserve on Wednesday held US interest rates at a 22-year high, but officials forecast that the central bank would implement 75 basis points worth of cuts next year, setting off a sharp rally in US stocks and government bonds.
The unanimous decision from the Federal Open Market Committee extends a pause in monetary policy moves that has been in place since July, leaving the federal funds rate at 5.25 per cent to 5.5 per cent.
But new economic projections from individual central bank officials suggested they saw greater scope for the Fed to lower interest rates next year than in previous projections, amid an improvement in the outlook for inflation.
The so-called dot plot showed that most officials expected rates would end next year at 4.5 per cent to 4.75 per cent, suggesting the Fed would make three quarter-point cuts from current levels. The dot plot showed expectations for rates to fall even lower in 2025, with most officials forecasting rates would end up between 3.5 per cent and 3.75 per cent.
Expectations for a steeper pace of rate cuts next year triggered a rally in US stocks and sharp fall in Treasury yields, with the two-year yield recording its biggest daily decline since the collapse of Silicon Valley Bank in March.
In a statement, the Fed spelt out the conditions under which it would consider “any additional policy firming that may be appropriate to return inflation to 2 per cent over time” – softer language that suggests the central bank may not see a further need to raise rates again.
Speaking at a press conference, Jay Powell, Fed chair, said the inclusion of the word “any” reflected a view that the policy rate was “likely at or near its peak for this tightening cycle”. He also added that while officials “do not view it as likely to be appropriate to raise interest rates further, neither do they want to take the possibility off the table”.
Powell reiterated that the central bank was committed to proceeding “carefully” with future rate decisions given expectations that economic growth would cool and there had been “real progress” on beating back inflation.
“They went from higher for longer in September to talking about rate cuts,” said Priya Misra, a portfolio manager at JPMorgan Asset Management. “They were behind the curve on inflation, but maybe they want to be ahead of the curve in terms of a slowdown.”
The two-year Treasury yield, which moves with interest rate expectations, fell 0.29 percentage points to 4.42 per cent after the Fed’s announcement. The benchmark 10-year Treasury yield fell 0.19 percentage points to 4 per cent, its lowest level since August.
The benchmark S&P 500 rose 1 per cent, to its highest intraday level since January 2022.
The latest decision comes as the Fed tries to keep monetary policy tight enough to drive inflation back down to its 2 per cent target without damaging the economy and causing too many job losses.
Some traders in futures markets had expected the central bank to begin lowering borrowing costs as early as March, although this week’s inflation data and a solid jobs report on Friday prompted more bets that cuts will begin in May. Leading up to Wednesday’s rate announcement, traders had wagered interest rates could fall more than a percentage point next year.
Projections from Fed officials for unemployment were barely changed from September, with officials still expecting only a slight uptick in the jobless rate to 4.1 per cent in 2024, from 3.7 per cent now.
However, estimates for core inflation, as measured by the personal consumption expenditures index, were lowered slightly, with officials expecting it to hit 2.4 per cent in 2024 and 2.2 per cent in 2025. In September, median projections showed inflation hitting 2.6 per cent in 2024 and 2.3 per cent the following year.
To consider rate reductions, the Fed needs to be confident that inflation is trending back to 2 per cent in a sustainable way. If slower consumer price growth is accompanied by a sharp rise in unemployment, the rationale to cut would be clear.
“We’re aware of the risk that we would hang on too long,” Powell said, referring to waiting too long to cut rates. “We know that’s a risk and we’re very focused on not making that mistake.”
He later added the Fed would not wait until inflation had returned to 2 per cent to begin to cut rates because “you’d want to be reducing restriction on the economy well before” that point “so you don’t overshoot”.
The looming question is what happens if the economy holds up as inflation falls. Some officials such as John Williams, president of the New York Fed, and Christopher Waller, Fed governor, have suggested that loosening monetary policy could still be necessary so that interest rates, once adjusted for inflation, do not become too restrictive for households and businesses. – Copyright The Financial Times Limited 2023
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