Economic Commentary

Economic Commentary

January 31, 2024

Fed holds rates and removes tightening bias, but not rushing to cut rates

Executive summary

Federal Reserve (Fed) policymakers kept the federal funds rate unchanged (target range of 5.25%-5.50%), which was widely expected. The meeting statement language shifted, removing the bias to tighten. Yet, the statement also pushed back on cutting rates until it has more confidence that inflation is sustainably moving lower.

Chair Jerome Powell was explicit that the committee probably won’t cut rates in March. Stocks immediately reacted negatively that a March rate cut wasn’t likely. U.S. Treasury yields rose slightly during the press conference but ultimately resumed their decline (i.e., price rally).

Ultimately, the Fed will remain patient for now with respect to cutting rates. We believe it’s likely that the Fed will begin lowering rates in May. That would ease financing pressures on consumers and businesses alike, making a soft landing more achievable.

What happened

At its January rate-setting meeting, the Federal Open Market Committee (FOMC) unanimously agreed to leave its target range for the federal funds rate in a range of 5.25% to 5.50%. That's the fourth consecutive meeting it held rates steady. The Fed is also maintaining the current pace of its balance sheet runoff (i.e., quantitative tightening) at roughly $90 billion per month.

Chair Powell spent the bulk of the post-meeting press conference clarifying the notion of “the confidence that inflation is sustainably moving lower.” For instance, media questions were, “What would it take to gain more confidence? Given that inflation has receded, how much more does inflation need to fall before the committee is satisfied?” Powell parried those questions by reiterating that more data was needed to confirm inflation would continue trending lower.

Powell stated that rates very likely have reached their peak for this cycle. But followed that up by plainly stating that the committee probably won’t cut rates in March.

Once again, Powell reiterated that “no one is declaring victory” over inflation, along with “we haven’t achieved a soft landing yet.” 

Our take

We didn’t expect any action at this meeting, which is what occurred. Yet, we were surprised that Chair Powell seemingly gave markets what they wanted on one hand – “rates had likely reached their peak for this cycle” – and then yanked it away almost as quickly by saying the March rate cut probably wasn’t happening.

That said, we agreed with Powell’s sentiment. Inflation has indeed receded of late, but faster growth remains a risk insofar as prices could pick up again, undoing the hard-fought work to mollify inflation expectations. And growth has moderated generally but remains solid by many measures. In other words, the path for a soft landing is widening.

Accordingly, the Fed will remain patient for now with respect to cutting rates. However, it will begin lowering rates in the coming months – probably in May in our estimation. That would ease financing pressures on consumers and businesses alike, making a soft landing more achievable.

Bond market reaction

In the immediate aftermath of today’s Fed announcement, U.S. Treasury yields retraced a small portion of their earlier decline across the curve but ultimately resumed their decline (i.e., price rally). The policy-sensitive 2-year yield settled around 4.22%, 11 basis points (0.11%) lower than Tuesday’s close. The 10-year maintained its move below the 4% threshold, trading at 3.94% as of this writing.

As we stated following the December FOMC meeting, the Fed remains steadfast in returning inflation to its 2% long-run objective. Policymakers underlined this commitment today by stating their need for further confidence that inflation is cooling sustainably. Whether or not the Fed will have sufficient evidence in-hand by the March meeting remains an open question, but today’s rate decision and press conference pushed against the notion of imminent policy easing as a foregone conclusion. In response, traders tempered their rate cut bets for the next FOMC meeting, now pricing in a 37% probability – well below the 90% chance market’s expected just a month ago. We continue to believe the initial rate cut will arrive closer to the summer.

Over the past few months, as the Fed shifted discussions from tightening to easing policy in response to cooler inflation readings, U.S. yields have fallen precipitously. 2-year and 10-year U.S. Treasury yields are more than 100 basis points (1%) lower than their mid-October peaks. While federal deficits and strong government debt issuance may dampen moves lower, yields tend to fall in environments like today – where growth is stepping down and the Fed is preparing to loosen monetary policy.

Expectations for decelerating domestic economic growth support our emphasis on high quality fixed income, which tends to outperform riskier fixed income sectors in such an environment. Current credit spreads – particularly in the high yield sector – insufficiently compensate investors for downshifting growth and rising defaults. While we still see value in duration, the magnitude of the bond rally over the past three months supports a more neutral duration posture within fixed income portfolios.

Bottom line

The resilience of the U.S. economy has pushed Fed rate cuts back a few months from market expectations. We believe it’s likely that the Fed will lower rates in May. And lower rates would make a soft landing more achievable in our opinion. 

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