After nearly two years of raising the federal funds rate to restore price stability, the Federal Reserve is poised to all but declare that campaign to be over at its meeting next week.
We expect that the Fed will offer a more encouraging outlook on growth, employment and inflation and set the stage for rate cuts.
While the Federal Open Market Committee is likely to keep its policy statement largely unchanged, that statement will almost certainly be trumped by an improved outlook in the FOMC’s Summary of Economic Projections.
We expect that the SEP will offer a more encouraging outlook on growth, employment and inflation, and also include a reduction in the median outlook for interest rates next year, or the dot plot, from 5.125% to 4.875%.
That reduction will partially affirm recent pricing in financial markets predicting that the Fed will cut its policy rate by 100 to 125 basis points next year. And given the improved outlook for the economy, Fed Chairman Jerome Powell will find it difficult not to sound dovish on the future of monetary policy when he addresses reporters after the meeting.
The Fed, though, will make clear that its efforts to restore price stability are not complete. The central bank continues to draw down its balance sheet by $95 billion a month, and has already reduced it from $9 trillion last year to roughly $7.8 trillion today.
But the Fed is approaching the point at which it will need to begin adjusting its rhetoric to prepare investors, policymakers and the public for cuts in the policy rate no later than the middle of next year.
We expect the central bank to keep its policy rate between 5.25% and 5.5% at next week’s meeting and refrain from major changes inside the policy statement.
But investors will focus on what we think will be an additional two rate cuts embedded in the Fed’s forecast and a reduction in the median dot plot for the end of next year to 4.875% even as the median dot plot for 2025 remains unchanged.
In addition, we expect the Fed to lower its inflation forecast for this year and next given the clear improvement in the pricing outlook.
Disinflation continues to drag down inflation growth ahead of what we expect will be further downward pressure inside both the consumer price index and core measures of the closely watched personal consumption expenditures index. One can see this relief on the way inside the Cleveland Federal Reserve New Tenant Rent Index.
In addition, we expect upgrades to the outlook for gross domestic product, which is currently on pace to grow by nearly 3% this year and, according to our forecast, by nearly 1.8% next year. That outlook is well above the Fed’s current forecast of 1.1%.
We also expect the Fed to lower its forecast for the unemployment rate this year to 4% from 4.1%, and to 4.3% next year, from 4.6%.
Although next week’s meeting will solidify market expectations that the Fed is finished raising rates, Powell will attempt to strike a delicate balance between expressing a willingness to hike rates again should inflation prove unexpectedly stubborn or even move higher.
But given the unambiguous improvement in economic data, a strong jobs market and rising real wages as inflation eases, it will be difficult for Powell to square that circle and kill the current buzz permeating markets around the direction of monetary policy.
Our forecast for the American economy next year implies that the Fed will cut its policy rate by 100 basis points starting in midyear as inflation eases and the central bank pivots toward bringing down real rates to improve business conditions and the cost of borrowing inside the American real economy.
The logic of Fed rate cuts
Market participants have priced in nearly a 60% probability of a rate cut at the Fed’s policy meeting in March and expect a reduction in the policy rate of close to 150 basis points by year end.
While we think that the timing and magnitude of those cuts appear somewhat premature, the logic of why the Fed will cut rates is increasingly coming into view as inflation eases and the risks linked to policy decisions made before and during the pandemic continue to reverberate.
Read more on RSM’s outlook for the economy and the middle market in 2024.
Much of the euphoria that has influenced pricing across asset markets over the past month has to do with the idea that the fight against inflation is over and that the Fed is poised to begin cutting rates sooner than had been expected.
Indeed, falling oil prices, sustained goods disinflation and slower job gains all imply that top-line and core inflation will continue to illustrate a slower pace of inflation.
More important, the recent easing in rents seen in high-frequency data will show up in a more forceful manner in both the consumer price index and personal consumption expenditures index, which should set the predicate for the first rate cut around the middle of next year.
With inflation easing back toward tolerable levels around 2.5% with risk of a lower rate by the end of next year, there is no reason why the Fed needs to maintain a restrictive policy rate near 5.5%.
Our estimate of the new Fed neutral rate is approximately between 3% and 3.5%, and we expect that as the central bank grows more confident in the direction of inflation, it will begin to cut rates especially after what we think will be lackluster growth in the first half of the year, when we expect an average expansion in economic activity of 1.3%.
Risks on the horizon
From our vantage point, the best monetary policy is forward looking and manages risk.
By the second half of next year, central bankers will be looking to ascertain risks that loom just over the horizon.
Those risks have to do in one part with the historically low interest rates put in place in 2020 and, in another part, with the scheduled expiration of the 2017 Tax Cuts and Jobs Act in 2025.
First, corporate debt that was taken on at the historically low interest rates put in place a response to the pandemic in 2020 will need to be rolled over starting in 2025 at much higher rates. More than $3 trillion in debt that needs to be rolled over in the coming years at rates much higher than in 2020, according to The Financial Times.
For example, a 5% rate on $800 million in debt issued in 2020 will simply not be replicated in 2025. The more likely scenario is that bankers will be willing to make similar loans at 8% but at lower levels, near $500 million.
That creates a $300 million gap that needs to be filled—probably by private credit and other shadow-banking actors, if it is filled at all. That gap, in turn, creates risk through the financial channel to the domestic corporate sector.
This maturity wall will play a much larger role in the policy narrative both inside the central bank and in Washington, where the issue is already being discussed ahead of what will be another contentious election year.
Second, the expiration of the tax cuts enacted in 2017 will create a significant tax cliff for the economy.
Based on our discussions with policymakers inside the nation’s capital, this expiration is already at the top of the policy agenda. It is clear to both sides that letting the corporate tax rate reset to levels that existed before 2017 is in no one’s best interest given the current higher level of interest rates.
Our evaluation of monetary policy implies that the Federal Reserve will reduce rates to protect the real economy next year as inflation eases and create the conditions for an orderly adjustment from past policy decisions.
But before the central bank moves to address those risks, it needs to wrap up its current policy path. We expect the Fed to all but declare that its rate hike campaign is over at its December policy meeting. We also expect that its Summary of Economic Projections will point to four rate cuts next year on the back of an improved outlook for growth, inflation and employment.