Interest rate futures view it as highly likely that the target rate for Federal Funds is held at 5.25%-5.5% at the conclusion of the U.S. Federal Reserve’s next meeting on January 31.
However, markets still see a 40% chance of rate cut at the subsequent meeting in March according to the CME’s FedWatch Tool. It’s unclear if Fed policymakers are ready to cut rates that early, even though statements from Fed officials have acknowledged that the macroeconomic outlook appears to be improving. It may be that the Fed start to bring rates down in the spring, assuming that they have sufficient data to be highly confident inflation is beaten.
Governor Waller Shares Optimistic Outlook
Fed Governor Christopher Waller said in terms of the macroeconomic environment “this is almost as good as it gets” at a speech at the Brookings Institution on January 16, given that inflation is close to 2% over the past 6 months and unemployment remains under 4%.
His main question was, will it last? Ultimately his verdict is that, “I am becoming more confident that we are within striking distance of achieving a sustainable level of 2 percent PCE inflation. I think we are close, but I will need more information in the coming months confirming or (conceivably) challenging the notion that inflation is moving down sustainably toward our inflation goal.”
In terms of policy, Waller stated, “As long as inflation doesn’t rebound and stay elevated, I believe the FOMC will be able to lower the target range for the federal funds rate this year.” Therefore, Fed officials are starting to signal, that absent a major change in the economic news 2024 rate cuts are very likely. Though he also noted, “I see no reason to move as quickly or cut as rapidly as in the past.”
Real Interest Rates
In his speech, Waller also referenced real interest rates, which are the level of interest rates adjusted for inflation. If inflation is at 10% but inflation is also running at 10%, then the real interest rate is the same as if inflation were at 2% and interest rates at 2%.
From this perspective, as inflation has cooled over 2023, so real interest rates have become more restrictive because of lower inflation. Roughly, with short-term rates at 5% that’s a lot more restrictive now annual inflation is running at 3% than when inflation was around 5% in spring 2023.
This logic implies that the Fed will be tempted to cut rates soon to avoid real interest rates getting too high, and potentially risking a recession from overly restrictive monetary policy, even though economic data has recently been favorable.
What To Watch For
The Fed’s language from its last meeting in December still refers to inflation as “elevated” and mentions “the extent of any additional policy firming”. That could change with January’s statement.
The Fed may increasingly soften their language to signal that rate cuts are more than likely on the horizon assuming no economic surprises. Although, of course, the Fed is likely take a position that keeps its options open. The Fed has already noted that all policymakers see interest rates either at current levels, or below, by the end of 2024, through the Summary of Economic Projections released on December 13, 2023.
The Timing Of Any 2024 Cuts
Therefore, the likely question is how much and how fast rates decline in 2024. Markets viewed a March cut as highly likely, as recently as last month. However, given recent cautious Fed statements, now markets see rates just as likely being held steady in March.
Importantly, markets imply it’s highly likely interest rates are lower by early summer. Fed leaders likely would not disagree with that view on recent economic evidence, but if so, the Fed policymakers will start to update their language at the January meeting to prepare for such a potential move in interest rates.