Fed Watch - Confidence is key
Confidence in inflation outlook will determine rate cut timing – The FOMC kept interest rates on hold today, but made important updates to its policy statement to shift more explicitly to an easing bias. Specifically, the statement added the line that ‘The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.’
In the press conference, Chair Powell later clarified that this would not have to mean ‘better’ data than we have seen so far on inflation, but rather a ‘continuation’ of the ‘good data’ we have already been getting on inflation over the past six months. Indeed, on the Fed’s preferred PCE measure of inflation, 3m/3m annualised price growth is already at or below the Fed’s 2% target.
Strong growth is no impediment to cutting – Powell importantly added that the Committee would not be looking for weaker growth to start cutting rates: ‘we don’t look at stronger growth as a problem’. This is because much of the has been driven by a significant improvement in the supply side, particularly the labour market. With regards to rate cut timing, Powell essentially ruled out a move in March (‘don’t think it’s likely’). This leaves the May or June meetings as the most likely start timing for rate cuts, assuming – as – that the run of benign inflation data continues. Our base case continues to be for a June start to rate cuts, as the Committee will also update its quarterly projections at that time.
The Fed looks likely to begin slowing its balance sheet runoff – or quantitative tightening – by mid-year, with a complete end to the programme by the end of 2024. The final noteworthy point from the press conference was on the future of QT. Powell announced that the Committee would begin an in-depth discussion on this topic at the March meeting. We think an announcement on the gradual phasing out (or tapering) of the programme could come as soon as March itself, with the winddown itself beginning mid-year, and QT ending entirely by end-2024.
This is because the usage of the Overnight Reverse Repo facility (RRF) has declined more quickly than expected – by $1.8tn to just $0.6tn as of last week. Some Fed officials view the RRF balance as a gauge for how much excess liquidity there is in the financial system. At the current pace of decline, use of the facility is likely to fall to zero by mid-year, by which point QT is likely to start putting downward pressure on bank reserves. In order to avoid a re-run of the market functioning problems resulting from too-low bank reserves that we saw back in 2018, the Fed will want to leave ample buffer this time around and therefore stop QT well before problems emerge.
An end to QT this year may seem premature, given the Fed’s balance sheet remains some $3.5tn higher than it was before the pandemic. Ending QT so soon could therefore be viewed by some as a de facto easing in monetary policy. However, US nominal GDP has increased by an even greater amount during this time – by $6tn. At the current pace of QT, by end-2024 the Fed’s balance sheet will be rapidly approaching the 19% of GDP level from before the pandemic. We therefore expect that the Fed will communicate clearly – and well ahead of time – to markets that an end to QT is about maintaining market functioning rather than altering the stance of monetary policy.
