The outlook for Federal Reserve rate cuts has divided Wall Street into two main camps. The no-landing camp thinks the higher inflation readings to start the year, solid job growth and a booming S&P 500 will keep the Fed on hold. The group forecasting a soft — or maybe slightly bumpy — landing expects sufficient disinflation progress and emerging signs of a slowdown to allow the Fed to deliver three or more rate cuts this year.
Both groups could be in for a surprise this afternoon, when the Fed will show its cards with guidance from chair Jerome Powell and updated quarterly projections. Powell may signal that a near-term rate cut could be in the cards, supporting the odds of a June move in something of a surprise for the no-landing camp. Yet Fed projections may pencil in one fewer rate cut in both 2024 and 2025 than they showed in December, surprising soft-landing forecasters.
That may be the best way for the Fed to balance its competing priorities: inoculating the economy against undue weakness from keeping rates too high for too long, while keeping a lid on the exuberance among investors and businesses that a rate-cutting cycle can spark.
The First Fed Rate Cut
Fed chair Powell's Jan. 31 news conference seemed to hint at policymakers' discomfort with the rate-cut outlook they offered in December: three quarter-point rate cuts this year and four more in 2025.
Powell stressed that the initial rate cut carries more significance than an ordinary quarter-point move, calling it a "highly consequential decision" that the Fed wants to get right.
Powell didn't explain why that first cut matters so much. But the implication is that it could send an all-clear signal on inflation and amplify expectations that a series of cuts will follow.
This also may have been on Powell's mind: In the 11 rate-cutting cycles since 1982, the S&P 500 has averaged a nearly double-digit gain in the six months following the first cut. That includes a 25% surge in the half year after the first rate cut in 1998.
Yet by reeling in its rate-cut outlook at this week's meeting, the Fed could send a message that subsequent cuts following an initial move won't be a given. That could give the Fed more leeway for a preventive, near-term quarter-point cut to help assure a soft landing.
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Fed Rate-Cut Odds
Ahead of today's Fed policy signals, market pricing shows 60% odds of a quarter-point rate cut by the June 12 meeting. Further out, markets are pricing in a year-end Fed funds rate of 4.64%. That implies a strong likelihood (65% odds) of at least three quarter-point cuts from the Fed's current 5.25% to 5.5% range.
The market pricing suggests that, while the Fed rate-cut outlook has split Wall Street into two camps, more money is behind the soft-landing camp. Yet the soft-landing camp may be underestimating the Fed's concern about easy financial conditions and its reluctance to add fuel to the AI stock boom.
What's Changed Since Dec. Fed Meeting
One thing seems clear: The Fed has a different set of cards than it held on Dec. 13, when policymakers penciled in 75 basis points in rate cuts for 2024. Since then, GDP and job growth have come in hotter than expected, while the S&P 500 has scored one record high after another.
By the Jan. 30-31 meeting, some Fed policymakers were already getting nervous about too-easy financial conditions, meeting minutes revealed. The risk that the wealth effect from a roaring bull market would boost consumer spending and stall inflation progress likely played a big part in Powell essentially taking a March rate cut off the table. The S&P 500 has tacked on another 5% since Jan. 30, bringing its rally since late October to 25%.
Subsequently, hot January inflation data released last month pretty much torpedoed chances of a Fed rate cut at the May 1 meeting.
Still, Powell told Congress on March that cutting interest rates will be appropriate when the Fed gains sufficient confidence — "and we're not far from it" — that inflation is on a path to get back to 2%.
More Hot Inflation Data
That came before the latest batch of hot inflation data. After the consumer price index and producer price index data, economists expect the Fed's primary inflation gauge, the core PCE price index, to rise 0.3% in February. However, a big upward revision to health care inflation likely means that January's initially reported 0.4% rise in the core PCE price index will be revised to 0.5%.
Following CPI an PPI data, Nomura economist Aichi Amemiya wrote that Fed policymakers may "substantially" revise up their projection of 2.4% core inflation for 2024. That could go hand-in-hand with a revised outlook for just two rate cuts this year, he says.
Still, the Fed probably isn't overly concerned about the uptick in inflation in January and February after seven tame monthly readings that had seen the core inflation rate drop below 2% on a six- month annualized basis.
Laura Rosner-Warburton, founding partner of MacroPolicy Perspectives, wrote on Thursday that January's core PCE gain is likely to be revised up by 6 basis points from the initial 0.42% increase. However, services prices cooled off somewhat in February. "The mix suggests the start of the year price reset was larger but isn't repeating."
An Agile Fed
The divide over the Fed rate-cut outlook between the no-landing and soft-landing camps reflects a high degree of uncertainty about where the economy is headed this year.
That uncertainty was highlighted by last Thursday's data showing that retail sales slumped 0.5% over the three months through February vs. the prior three months, yet initial claims for unemployment benefits eased to a benign four-week average of 208,000.
Job growth has averaged a strong 265,000 per month over the past three months. Yet some forward indicators, such as the National Federation of Independent Business survey of small businesses, are pointing to weakness. NFIB data shows that the percentage of businesses planning to add jobs minus the percentage expecting layoffs slipped to 12% in February. That's the lowest level since May 2020.
Jefferies economist Thomas Simons wrote in a March 13 note that his base case has the economy weakening enough for the Fed to cut five times this year, starting in June. But if the economy continues to surprise to the upside, he says, the Fed likely won't cut at all.
Powell has said that the Fed's interest-rate setting is well into restrictive territory, meaning it is putting downward pressure on growth and inflation. If economic clouds are forming, the Fed should want to respond early to limit undue weakness.
Yet with such a wide range of outcomes for the economy this year, there's a risk in the Fed moving too early. That's why the challenge for the Fed on Wednesday is to reset market expectations to keep investors and businesses from turning overexuberant at the first rate cut.
S&P 500
So far, the S&P 500 has kept rising even as markets have gradually priced away expectations of a fourth, fifth and sixth rate cut. The AI stock rally has powerful drivers beyond Fed rate-cut hopes.
Still, investors aren't too nervous about how the Fed rate-cut outlook will change at this week's meeting. The S&P 500 slipped for the third-straight session on Friday for the first time since Jan. 4, but proceeded to close at a new record high on Tuesday. While an implicit Fed tightening — via fewer projected rate cuts — may cool off the S&P for a bit, it wouldn't be a game-changer.
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