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Fed Holds Rates Steady, Opens Door to Rate Cuts in 2024

Policymakers adopt a more dovish outlook amid easing inflation and slowing growth.

12/13/2023

Key Takeaways

The Fed left rates unchanged but stopped short of declaring victory in a lengthy battle against inflation.

While the Fed’s prior pauses accompanied a hawkish tone, the latest pause is surprisingly dovish.

We still expect Fed tightening and other factors to thwart growth in 2024, highlighting time-tested investing strategies.

As expected, the Federal Reserve (Fed) held rates steady again on Wednesday. The decision marked the third consecutive pause in the central bank’s fastest rate-hike campaign in 40 years. The Fed’s target short-term lending rate remains at a 22-year high range of 5.25% to 5.5%.

More surprisingly, Fed officials penciled in three interest rate cuts in 2024, representing a significant change in the Fed’s quarterly Summary of Economic Projections (SEP). In the September SEP, only five policymakers expected to cut rates at least three times in 2024. In the latest projections, 11 Fed members forecasted three or more rate cuts next year.

The Fed’s interest rate decision and SEP followed a larger-than-expected slowdown in inflation, a recent sharp drop in Treasury yields and moderating job growth:

  • Headline inflation in November slowed to an annualized pace of 3.1%, compared with 3.2% in October. Core inflation (excludes food and energy prices) was unchanged at a two-year low of 4%.

  • The 10-year Treasury yield, which topped 5% in October for the first time since 2007, plunged to 4.1% by early December.

  • Since peaking in March 2022, year-over-year wage growth has steadily declined. The U.S. Bureau of Labor Statistics reported wages grew at a 4.2% annualized pace in September versus 5.9% in March 2022.

These data points align with our long-standing economic outlook and contribute to our belief that a recession will likely occur next year.

Fed Proceeds on an Economic Tightrope

Policymakers cited continued progress in slowing the pace of price gains but weren’t ready to declare victory in their 22-month battle with inflation. After lifting short-term interest rates by 5.25 percentage points in only 16 months, the Fed prefers to proceed cautiously.

Powell wouldn’t rule out the potential for additional tightening in his post-policy meeting press conference on Wednesday. As unlikely as more rate hikes seem, particularly given the latest SEP, Powell cited the economy’s surprising resilience as a reason to tread carefully. But he also noted that a rate-cut timetable is a “topic of discussion.”

If policymakers cut rates too soon, they risk perpetuating a higher-than-target inflation rate. If they wait too long to cut rates, they risk stalling growth and triggering higher unemployment.

Market Expects the First Rate Cut in March 2024

With Wednesday’s interest rate decision and economic outlook, the Fed finally appears to be moving closer to market expectations. For several weeks, the futures market has expected rates to decline steadily through 2024. Figure 1 shows the market’s latest implied path for the federal funds rate target.

The futures market anticipates the first Fed cut will come in March. Current forecasts see as many as five more quarter-point cuts to follow by year-end.

Figure 1 | Futures Market Sees Implied Rate Steadily Falling Next Year

Bar chart showing the implied Federal Funds Rate is expected to fall to around 4.2 percent by December 2024. The next Fed move is expected to be a rate cut.

Data as of 12/13/2023. Source: Bloomberg.

Fed Sees Slowing Growth; We Still See Recession

The SEP accompanying Wednesday’s monetary policy decision indicates that most Fed members expect the economy to grow at a weaker pace next year. In the Fed’s September SEP, members projected a 1.5% growth rate for 2024. The Fed lowered its growth projection to 1.4% in Wednesday's SEP.

Policymakers forecast inflation to ease but remain above their 2% target. They also expect the unemployment rate to climb from 3.8% this year to 4.1% in 2024.

Our growth forecast for next year isn’t as optimistic as the Fed’s. We believe aggressive rate hikes, tighter financial conditions and the cumulative effects of higher prices will continue to weigh on the economy. Additionally, depleted savings, soaring credit card debt and the resumption of student loan repayments should further pressure consumer spending.

As spending subsides and the economy broadly weakens, we expect the job market to slow. This backdrop should lead to a further slowdown in the inflation rate—and even outright deflation in certain sectors. Against this backdrop, the yield curve should move lower.

In our view, this combination of factors will trigger an economic downturn by mid-2024. Given our outlook for recession, we believe emphasizing higher-quality equity and fixed-income securities remains warranted.

Author
Charles Tan
Charles Tan

Co-Chief Investment Officer

Global Fixed Income

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