The Fed needs to shift into easing mode soon to increase soft landing odds
The first Fed meeting of 2024 takes on greater importance post the Powell pivot at the December FOMC meeting. Meanwhile, the inclusion of QT taper talk in the December minutes (along with fresh Fedspeak on QT), plus changes to the Bank Term Funding Program (BTFP), suggest there is a lot hanging in the balance, and at a minimum, there is plenty to focus on at the January FOMC.
Before we lay out scenarios for the upcoming meeting, it’s important to put into context our medium-term views for policy rates and balance-sheet policy. We believe this easing cycle will not end in zero rates (as in prior cycles) and that when the Fed states they want rates “higher for longer”, they do not have a target in mind; instead, they want rates to be near or above neutral (~3%).
- We maintain our view that the first likely cut for the upcoming easing cycle will be at the March meeting. We have had this initially out-of-consensus view since mid-summer 2023 (when hikes were being still priced-in) because of cycle timing and concerns around how to manage the balance-sheet and bank reserve levels. In order for us to change our view, the following needs to occur:
Fed communication/policy changes: If Powell sounds overtly hawkish (we do not expect this as per below) and pushes back on cuts, the Fed would need to adjust QT policy sooner rather than later (as a proxy for rate cuts).
- Economic developments: If the jobs data does not start to show declines and benchmark revisions are shallower than expected, or if manufacturing and services PMIs rebound, we reserve the right to push back cuts.
- Banking system/financial conditions: If US banks start to lend and liquidity issues fade while financial conditions get even easier, we push back cuts.
That said, here is how we see the potential scenarios for the January FOMC:
- Dovish (50%): Our base-case is for a more dovish official communiqué and press conference. We expect the statement to shift to a more neutral stance as the balance of risks between growth vs inflation move to equal importance. The key will be to watch Powell’s body language and tone. We expect the Q&A to force a dovish response to these questions: Do you still expect to cut “well before 2%”? Why was BTFP altered? At what stage (if there isn’t an official release in January) is the FOMC at in terms of tapering QT? Any mention that real rates are now “too restrictive” would be very dovish too.
- Neutral (30%): If the statement is neutral, chair Powell can play it down the middle, emphasizing that the Fed remains data dependent and open-minded.
- Hawkish (20%): The recent string of Fedspeak has been leaning hawkish, so it’s possible Powell echoes that and does his best at sounding hawkish. If he mentions financial conditions are too easy and that means there is no reason to “rush” and cut rate so soon, that would seriously disappoint markets.