We expect the Federal Reserve to reduce its policy rate by 25 basis points to a range between 4.25% and 4.5% at the Federal Open Market Committee’s meeting on Dec. 18.
We expect the Federal Reserve to reduce its policy rate by 25 basis points to a range between 4.25% and 4.5%.
Given current growth and inflation dynamics, we expect that the Fed’s rate cuts will then be on pause until March at the earliest.
We also expect that the central bank will change the wording of its policy statement to describe growth as strong and characterize labor market conditions as cooled rather than eased, which was used in September.
Federal Reserve Chairman Jerome Powell’s news conference afterward is likely to feature an emphasis on a strong economy characterized by recent cooling in the pace of hiring.
In addition, we think Powell will emphasize that future rate cuts will be slower and dependent on incoming data.
The Fed needs to ascertain what impact the new administration’s expansionary fiscal policy—increased federal spending and tax cuts—will have, in addition the administration’s far more elastic regulatory framework and tighter immigration policies.
While the Fed’s policy decision next week is likely to be labeled a hawkish cut, that label would lack depth and breadth in our estimation. Instead, a likely discussion of a prudent pause that is to come would acknowledge the significant changes in fiscal and trade policies that are coming.
Despite recent inflation data arriving hot, the Fed is well positioned to relax its policy rate.
Our forecast of the personal consumption expenditures price index, which is the Fed’s preferred measure of inflation and will be published on Dec. 20, two days after the Fed decision, implies a 0.2% month-over-month increase in the top-line index and a 0.3% rise in the core.
Such a reading would translate into a 2.5% annual increase in the PCE index and the core.
This affirms our forecast of a 25 basis-point cut, and the market is expecting the same. The federal funds futures imply a 98% probability of a rate cut and overnight index swaps indicate a 96% chance of a rate cut.
In the end, we think that the rate cut decision is a non-event and the focus will turn to the Summary of Economic Projections and Powell’s remarks afterward.
Summary of Economic Projections
One of the clear changes that the Fed is entertaining is lifting its estimate of the terminal rate, which sits at 2.9% because of sustained outperformance of the U.S. economy.
We expect the Fed to increase its estimate of the terminal rate to 3% in the Summary of Economic Projections.
Based on our estimate, the current optimal federal funds rate should stand at 3.81%, which implies a terminal rate between 3.75% and 4%.
Read more of RSM’s insights on the economy and the middle market.
All this implies a further upward migration in the Fed’s estimate of the terminal rate next year.
The outperformance of the U.S. economy points to a reduction in the median unemployment rate from 4.4%, which was posted in September, to 4.2%.
In addition, the 2024 median estimate of growth, which was set at 2% previously, should increase to close to 2.5% while the median estimate of inflation should be lifted from 2.5% for the PCE index and 3% for the core PCE.
Next year, we expect the Fed to lift its growth estimates and dampen its unemployment projections. We also expect the Fed to increase its estimate of median inflation over the next two years.
The Federal Open Market Committee’s interest rate forecast, known as the dot plot, will show a median estimate of next year’s federal funds rate of 3.625%, which reflects a 25 basis-point increase from the September forecast.
We think that the estimate for next year will reflect a 25 basis-point increase to 3.125%.
