Fed Slowly Building the Confidence to Cut

The Federal Reserve sees progress on inflation, but wants more certainty before it’s prepared to lower the policy rate.

Balancing progress on taming inflation against still-resilient U.S. economic growth, the Federal Reserve in January clearly signaled its next move is likely to be a rate cut, but it is keeping its options open on timing – and the next meeting in March may be too soon.

Barring a material weakening in economic activity, we believe the Fed will wait until closer to midyear to begin its easing cycle with a 25-basis-point (bp) rate cut. As for subsequent rate cuts, the Fed’s latest projections (from December) suggest a 25-bp cut at every other meeting, but that pace could be adjusted depending on macro developments.

In our view, the risk of inflation getting stuck at above-target levels, or even reaccelerating, remains crucial for Fed policy, although we agree with the Fed’s assessment that risks have moved into better balance recently.

Waiting for more good data

While technically March could be in play after the Fed (as expected) removed the hawkish hiking-bias language previously present in its policy statement, the Fed also added the caveat that it does not expect to reduce the policy rate until it has gained “greater confidence” that inflation is moving sustainably toward its 2% target. At the post-meeting press conference, Fed Chair Jerome Powell said, “I don’t think it is likely that the Committee will reach a level of confidence by the time of the March meeting to identify March as the time [to cut], but that is to be seen.”

Developments on inflation and other macro factors since the December Fed meeting have had mixed implications for policymakers. U.S. core PCE (personal consumption expenditures) inflation has continued to move in a good direction, and is back in “2-point-something” territory. However, core CPI (consumer price index) data has remained firmer than PCE for several reasons, including the higher weight of shelter costs within the CPI calculation, and a faster decline in some non-market pricing categories within PCE – mainly healthcare. Although PCE is the Fed’s preferred inflation measure, the sticky CPI data does complicate its policy decisions, perhaps prompting some of the hesitation conveyed in the “greater confidence” line.