Tonight's Federal Reserve interest rate decision, will it stage a "hawkish rate cut" script?
A 25 basis point rate cut in December is almost a certainty, but caution is needed as Powell may send "hawkish" signals. Due to stronger-than-expected economic data, Wall Street believes that long-term neutral interest rates and inflation forecasts will be slightly adjusted upward, and a pause in rate cuts may occur in January next year
The Federal Reserve's December interest rate decision, with a 25 basis point rate cut almost a certainty, but caution is needed regarding Powell's "hawkish" signals.
At 3 a.m. Beijing time on Thursday, the Federal Reserve will announce its last interest rate decision of the year, along with the latest dot plot, economic, and inflation forecasts. According to market pricing, the probability of a 25 basis point rate cut is as high as 95%, which, if in line with expectations, will lower the target range for the federal funds rate to 4.25%-4.50%.
Due to stronger-than-expected economic data, Wall Street generally believes that there will be a slight upward adjustment to the long-term neutral interest rate, which would indicate that Federal Reserve officials are inclined to slow the pace of rate cuts.
Federal Reserve Chairman Powell will hold a monetary policy press conference 30 minutes after the decision is announced. Be cautious of Powell releasing "hawkish" signals; he recently stated that against the backdrop of a "strong" economy, the Federal Reserve "can be a little cautious" and see how the pace of rate cuts unfolds. It is worth noting that Powell may not provide forward guidance on fiscal policy following Trump's election.
Is a rate cut on Thursday a done deal? Beware of the possibility of "hawkish rate cuts."
Despite strong expectations for a rate cut, there remains some uncertainty. On Monday, Nick Timiraos, a journalist for The Wall Street Journal, known as the "new Federal Reserve whisperer," expressed a relatively hawkish view on social platform X. He wrote:
The market believes that a 25 basis point rate cut this week is almost a done deal, but since the current policy rate is 75 basis points lower than it was when the labor market appeared more unstable in September, confidence in the rate cut has weakened. Currently, there are reasons to support both a rate cut and maintaining the rate.
As Timiraos fears, if the Federal Reserve continues to cut rates on Thursday, it would mean that the federal funds rate has cumulatively decreased by one percentage point since September. This would represent a significant easing in a short period.
"I tend to support not cutting rates," former Kansas City Fed President Esther George said in an interview with CNBC on Tuesday. "As inflation data comes in, we find that inflation is not continuing to slow down as it did before."
So, I think this is a cautious reason, and we should seriously consider how much policy easing is needed to keep the economy on track.
Given that the inflation rate is still above the target level, the Federal Reserve is likely to use various tools to signal to the market that rate cuts will not come easily in the future.
"We will see them follow the trend and begin to raise their inflation expectations," said Vincent Reinhart, chief economist at BNY Mellon and a former 24-year veteran of the Federal Reserve's monetary affairs division
The forecast values of the dot plot will also rise slightly, with particular attention at the press conference on discussions about skipping certain meetings. Therefore, this somewhat reflects a hawkish tendency, despite the possibility of rate cuts.
If the neutral interest rate is raised, does it mean skipping the rate cut in January?
Due to stronger-than-expected economic data, analysts generally expect a slight upward adjustment in inflation forecasts for the coming year.
According to Nomura Securities' forecast, the core PCE inflation rate for 2024 is expected to be raised from 2.6% in September to 2.8%, with 2025 at 2.3% (up from 2.2% in September), while the unemployment rate forecast for 2025 is adjusted down from 4.4% to 4.2%.
In addition, the median dot plot (SEP median projection) is also expected to show a slight upward adjustment in the neutral interest rate.
Deutsche Bank's Brain Liu analyst team pointed out in an earlier forward-looking report that due to factors such as supply chain issues and a tight labor market, the median forecast of the dot plot will show that the long-term neutral interest rate will rise from 2.875% in September to 3.125%. The forecast for the nominal neutral interest rate in 2025 is between 3.75% and 4%, significantly higher than the current Federal Reserve forecast.
The team noted that in the past three published SEPs, the long-term neutral interest rate has risen and is very fragile, with just one upward revision sufficient to raise the median.
An upward adjustment in the neutral interest rate valuation will provide strong justification for pausing rate cuts in January, especially considering the uncertainties brought by Trump 2.0. Both Goldman Sachs and Barclays expect that the Federal Reserve will "pause" rate cuts in January.
Goldman Sachs' report released earlier this week pointed out that recent official speeches indicate that the Federal Reserve "clearly" wants to slow down the pace of rate cuts. The reason is that the unemployment rate is expected to be lower than the Federal Reserve's forecast for 2024, while the inflation rate remains above the target level. Additionally, given the uncertainties of the Trump administration, especially regarding possible tariff policies, Federal Reserve officials are more likely to remain cautious.
Goldman Sachs expects the long-term neutral interest rate to be raised by 12.5 basis points to 3%, which is consistent with the forecasts of Barclays and Nomura.
In the future, will the pace of rate cuts slow down?
According to Goldman Sachs' report, the focus of the Federal Reserve's statement will be on whether to emphasize slowing the pace of rate cuts or continue to stress "meeting decisions" and "data dependence." Goldman Sachs expects both types of statements to appear, but may increase hints at slowing the pace of rate cuts.**
Goldman Sachs also expects that the dot plot will show three rate cuts in 2025 to 3.625%, two rate cuts in 2026 to 3.125%, and maintaining 3.125% in 2027, all of which are 25 basis points higher than the September forecast.
Regarding the specific path of rate cuts, there may be differences among FOMC members:
Some members may prefer a more specific meeting plan, which means a stable quarterly path of four rate cuts in 2025 and one rate cut in 2026.
Other members may focus more on the appropriate total number of rate cuts each year, with most likely choosing three rate cuts in 2025 and two rate cuts in 2026.
Other Points of Concern: Reverse Repo Rate and Balance Sheet Reduction
In this monetary policy meeting, the Federal Reserve may also discuss lowering the overnight reverse repo rate (RRP) from 5 basis points above the federal funds rate target range to align with the target range.
This may be to stimulate liquidity to flow out of the RRP tool more quickly, but trading volume is declining on its own, and the current reverse repo balance has fallen to around $100 billion, the lowest since April 2021.
The Federal Reserve may further slow down the pace of balance sheet reduction in the future to avoid a liquidity shortage crisis similar to that in September 2019. The most likely scenario is to gradually reduce the scale of Treasury balance sheet reduction while continuing to reduce holdings of agency mortgage-backed securities (MBS)