Evening Brief – 12.21.23
Fed Vs. Markets
The financial markets are growing more convinced that the Federal Reserve will begin lowering the Federal funds target range in 2024. The first cut is anticipated at the March 20 FOMC meeting. The CME FedWatch Tool funds futures are currently pricing in a 71% probability of a quarter-point rate drop at the meeting.
At the December 13 FOMC meeting, the committee, in its Summary of Economic Projections, or dot-plots, penciled in three quarter-point rate cuts in 2024.
Interest rate traders, meanwhile, have taken a much more dovish stance, pricing in about 125 basis points of interest rate cuts. The relatively wide difference between the Fed and markets can be viewed as a proxy for market expectations of the direction of monetary policy. On that premise, the market perceives increased odds for looser monetary policy through a U.S. 2-year yield that is about a hundred basis points lower than the lower bound of the current Fed funds target range.
The aggressive rate-cut probabilities priced in by the financial markets, however, which has triggered a massive rally in risk-on assets, has received pushback from several FOMC officials in recent days.
Chicago Fed President Austan Goolsbee (CNBC) said he was surprised by the outsize market reaction to the Fed’s updated quarterly economic projections. Cleveland Fed President Loretta Mester (FT) and San Francisco Fed President Mary Daly (WSJ) said rate cut expectations for early next year were premature.
The Fed believes it can keep inflation under control, yet the labor market is strong, and the economy is still growing nominally. One can conclude that monetary policy is indeed restrictive based on the ratio of employment data, which remains reasonably solid, and inflation data, which has been on a steady downward path since reaching a high of 9% in June of 2022. This would signal that the central bank has room to decrease rates while remaining slightly hawkish.
If the Fed does cut interest rates, the $64,000 question for the markets is whether the policy adjustment would be driven by rising risk of a recession or increased confidence that inflation will continue to head lower?
Michael Gapen, head of US economics at Bank of America Securities, told CNN that it’s reasonable to dismiss recession risk as the cause for predicted rate cuts. “This cutting could be different than any other time,” he added, arguing that looser policy will be motivated mostly by inflation approaching the Fed’s 2% target.
The risk of recession appears to be low based on the Atlanta Fed’s GDPNow model’s fourth-quarter GDP nowcast, which forecasts growth at a relatively solid 2.7% real, seasonally adjusted annual pace.
Although that’s well below the impressive 5.2% increase in the third quarter, the fact that the Q4 nowcast has strengthened this late in the quarter implies a relatively high confidence estimate for the GDP report that will be released in January.