Highlights of the Federal Reserve next week: December rate cut is a certainty, but January is uncertain
Due to the dovish comments from Goolsbee suggesting that interest rate cuts in 2025 may slow down, market expectations for rate cuts have tightened. Morgan Stanley believes that the market's expectations for a rate cut in January next year are relatively conservative, as Goolsbee's remarks were made before the inflation data was released. The continued slowdown in inflation, especially housing inflation, will prompt the Federal Reserve to cut rates consecutively in the December and January meetings
Expectations for a pause in interest rate cuts next year are rising, with long-term U.S. Treasury bonds experiencing five consecutive declines, facing their worst week of the year. The market's expectations for the Federal Reserve's future policies have become more cautious, especially regarding the pace of rate cuts in 2025.
On December 14, Eastern Time, Morgan Stanley released a forward-looking report indicating that the dot plot to be published by the Federal Reserve next week will show that the median interest rate expectation for 2025 remains around 3.375%, lower than the market's expected bottom range of 3.4% to 3.7%. Investors should pay attention to the downward trend in housing inflation, as the Federal Reserve may cut rates twice in a row in December this year and January next year.
As the Federal Reserve meeting approaches, Morgan Stanley states that the three key issues investors are focusing on are: the expected dot plot for the Federal Reserve's interest rates in 2025, Chairman Powell's statements on the pace of rate cuts, and the decision on the overnight reverse repurchase rate.
Dot Plot: Median Rate Next Year Below Market Expectations
Since the end of October, the market-implied bottom range for the Federal Reserve's policy rate (i.e., the lowest expected rate) has remained in the range of 3.4% to 3.7%, slightly higher than the median point for 2025 in the September economic forecast summary, and far above the long-term median rate.
Morgan Stanley economists expect that the median interest rate expectation for the 2025 dot plot to be released next week may remain around 3.375% for at least three months. This expectation is below the lower limit of the market's original expected range.
Therefore, the market will view this as a signal of looser monetary policy, and the expectations for interest rates (the market-implied bottom range) may temporarily decline. This change may be further confirmed after the dot plot is released and before the press conference.
Powell's Press Conference: Market Overinterprets Cautious Remarks
After investors digest the FOMC statement and the dot plot, attention will shift to Chairman Powell's press conference. Most investors expect Powell to hint that the pace of rate cuts in 2025 will slow down while retaining the usual phrasing of "data dependence," meaning future policies will be determined by changes in economic data.
Morgan Stanley points out that most investors believe Powell's cautious signals suggest that there may not be rapid rate cuts in January next year. Although they understand that policies will change based on economic data, they often overinterpret Powell's hints, potentially leading to overly aggressive expectations for rate cuts in January 2025, overlooking the uncertainty of "data dependence."
The market's reaction can be seen in the two "good" inflation reports (CPI and PPI) released this week, where the market's response to the latest inflation data has been relatively muted, stemming from investors still grappling with previous comments from Federal Reserve officials.
For example, next year's voting member, the dovish Charles Evans, President of the Federal Reserve Bank of Chicago, has frequently stated that as rates approach the "neutral rate," the pace of rate cuts should slow down, as monetary policy's impact on the economy is lagged.
However, at the Chicago Fed's annual economic outlook seminar on December 6, Evans's remarks showed a subtle shift. Media reports indicated that he hinted at a series of "difficult choices" in future meetings, but he believes that rates still need to be "significantly lowered." At the same time, reports suggest he thinks the pace of rate cuts may slow down next yearThis viewpoint has sparked widespread attention in the market, as he is one of the more dovish officials within the Federal Reserve. If such a dovish Federal Reserve official suggests that the pace of interest rate cuts may slow down next year, investors will naturally interpret the risk as leaning in that direction, expecting future rate cuts to be more cautious and gradual.
However, Morgan Stanley pointed out that Goolsbee's last public appearance was before the release of relatively mild inflation data in November, and his views may not fully take into account the latest inflation data. Other Federal Reserve officials, such as the comments from Fed Governor Waller in September, indicate that inflation remains a key factor in decision-making.
Waller stated that if economic data continues to be weak, he would be more willing to take more aggressive rate cuts to bring inflation closer to the Federal Reserve's target.
Morgan Stanley noted that if Federal Reserve Chairman Powell does not hint at slowing the pace of rate cuts at least in the early meetings of 2025 during the press conference, investors may feel more confident that the probability of a rate cut in January is higher.
Inflation is the Key Factor: Housing Inflation Will Continue to Slow
Morgan Stanley previously pointed out that due to the decline in housing inflation in the November CPI report, market expectations for a rate cut by the Federal Reserve in January have increased.
Specifically, the strong performance of core commodity prices reflects the impact of hurricanes (considered a temporary "noise"), while the slowdown in rents and owners' equivalent rent (seen as a "signal") indicates a downward trend in housing inflation, bringing optimistic signals to the market.
Waller mentioned in an interview after the September meeting that the pace of inflation decline is faster than he expected, which is one of the reasons supporting larger rate cuts. Waller and his team conducted a simple calculation that if housing inflation grows at an annualized rate of 2% and this pace continues every month, the core PCE inflation rate would be below 1% over the past four months.
At the same time, Morgan Stanley economists' predictions for housing inflation also support this view, forecasting that the housing services inflation rate in core PCE will be 0.24% per month. This indicates that housing inflation will continue to slow in the coming months, which will provide greater confidence to the Federal Reserve, allowing them to believe that the downward trend in inflation remains intact, and enabling the Federal Reserve to cut rates consecutively in the next two policy meetings.
Therefore, considering the latest changes in inflation data, Morgan Stanley stated that current market expectations may underestimate the likelihood of a rate cut in January. Currently, market pricing suggests that the probability of another rate cut in January next year is relatively low, at about 25%.
