We anticipate that the Federal Open Market Committee meeting on March 19 and 20 will maintain the status quo in its policies.
Our forecast implies no change in the federal funds rate, which will remain in a range between 5.25% and 5.5%.
Our forecast implies no change in the federal funds rate, which will remain in a range between 5.25% and 5.5%. The FOMC’s median projection for interest rates in its dot plot should remain unchanged for this year at 4.625% as will the three rate cuts that are implied by the FOMC forecast.
We continue to expect that Fed will embark on a multiyear rate-cutting cycle at the June meeting that will feature three 25 basis-point cuts through the end of the year with the ultimate end point of 2.5% in 2026.
While we expect no change to the FOMC’s formal statement, it will be accompanied by a modest update to the Summary of Economic Projections that will most likely feature an upgrade to the forecast for this year.
We also do not expect any changes to the unemployment rate or to inflation forecasts, despite the recent stronger-than-expected inflation data, over the next three years or in the long run.
There are risks to the outlook, though. With the economy continuing to outperform and consumers still resilient, the Fed might be far more patient on rate cuts than either its forecast implies or the market has priced in. The result could be the central bank reducing its policy rate twice, or possibly fewer times, through the end of the year.
If there is any change in the median dot plot for this year or next, then one should anticipate moves across asset classes and a substantial repricing of risk.
Perhaps the most interesting aspect of the FOMC meeting is what will not appear in the March statement nor its Summary of Economic Projections regarding its program of quantitative tightening, or balance sheet reductions.
As it stands, the Fed is reducing its balance sheet by $60 billion per month in government Treasury bills and by $35 billion per month in mortgage-backed securities. Since April 2022, the Fed has reduced its balance sheet from $8.5 trillion to roughly $7 trillion recently.
But that pace is likely to be slowed, and it is certain that this will be one of the major topics on the table this week. We expect the Fed to announce the change to its tapering operations at the June meeting with a July start date, with the initial reduction in the Treasury notes runoff from $60 billion to $20 billion and the cap on the reduction of mortgage-backed securities reduced to $20 billion.
Market reactions
Betting on the direction of the bond market has always been nuanced, with 10-year bond yields embracing both perceptions of the direction of short-term policy rates and long-term growth as well as the equilibrium level of real interest rates.
We find the market setting of 10-year Treasury yields during the recent period of pauses in the Federal Reserve policy as changing over a short period of time that captures both the knee-jerk reactions in the aftermath of the publication of the policy statement and the SEP that tends to continue over the next two weeks.
Read more of RSM’s insights on the economy and the middle market.
In less than a year, market participants changed their mind on whether the economy might suffer another recession or is in the middle of a miracle recovery that will lead to sustainable long-term growth.
Betting against the equity market, however, even under the conditions of continued tightness of monetary policy, has been difficult to justify. In the last 12 months alone, the value of the S&P 500 index has increased by 30%, while tech stocks in the NASDAQ index have increased by 45%. This would seem to have little to do with the tightness of monetary policy.
Fed policy and 10-year yields
The Federal Reserve policy rate has held steady since last summer, but that hasn’t stopped the bond market from speculating what the upshot for inflation and growth might be.
During that time, 10-year Treasury yields spiked from 3.9% to 5.0% and then dropped as low again before settling in a range of 4.1% to 4.3% this year.
The first policy pause came last June, when the FOMC held the federal funds rate at 5.25%, taking time to determine the impact of previous rate hikes on its goals of full employment and price stability.
Two weeks later, the yield on a 10-year Treasury bond had dropped by a modest 8 basis points from 3.79% to 3.71%, with the market grappling with the possibility of an economic slowdown or recession.
But after the Fed hiked the federal funds rate to 5.50% on July 26, the bond market immediately pushed the 10-year up by 31 basis points and then higher to 5% even after the Fed stated its intent to put its rate-hike policy on hold as of Sept. 20.
By the FOMC meeting on Nov. 1, the bond market had changed its perceptions of Fed policy, prematurely pricing in the beginning of rate reversals as early as this month, resulting in a declining trend in 10-year yields that lasted until the end of the year.
Fed policy and the equity market
The response of the equity markets to Fed policy is a different animal.
After losing about 10% of its value in the three months after the Fed’s last rate hike on July 26, most likely because of perceptions of a policy-induced recession, the equity market has been on a tear.
The S&P 500 increased by 24% from late October through the first week of March and the tech stocks in the NASDAQ index increased by 29%, seemingly undaunted by each pause in Fed policy.
This stock market’s track record might have more to do with perceptions of an increasingly innovative economy than with the Fed’s attempt to limit demand to squash inflation.
The takeaway
We anticipate little change to the FOMC’s policy statement and to its Summary of Economic Projections at its next meeting. The clear focus will be on the median 2024 and 2025 dot plots. Any move up in the 2024 median dot of 4.625% will almost certainly cause a general repricing of risk across asset markets and alter forecasts of the timing and magnitude of the Fed rate-cutting cycle over the next two years.
While the sound and fury following such a move will garner plenty of attention, betting on the direction of interest rates after an FOMC announcement remains fraught will difficulty. We think that a focus on economic fundamentals and progress in the return to price stability is a better framework of understanding the interaction among the economy, financial markets and policy.
