The FOMC react to evolving risks
FOMC now see 75bps of cuts in 2024 and 100bps in 2025 as inflation abates and risks recede, but the underlying strength of the US economy remains.
At their December meeting, the FOMC again showed their actions depend on available data and perceived risks. Responding to success with inflation and clear evidence of the labour market coming into balance, the FOMC not only removed the additional hike forecast at September for 2023, but also added a cut to their 2024 view.
75bps of cuts are now projected by the Committee for 2024 to 4.6% followed by 100bps to 3.6% in 2025 and another 75bps to 2.9% in 2026. The fed funds rate is still expected to settle at 2.5% in the ‘longer-run’. To end-2025, the revised FOMC view is broadly in line with our established view of 100bps of cuts in both 2024 and 2025 to 3.375% at end-2025 to which the market signals there are downside risks.
Looking at the FOMC’s revised economic forecasts in detail, it is evident the revisions to the fed funds rate profile are a consequence of success with inflation. Having peaked at 10% and 6.5% respectively in 2022 on a six-month annualised basis, both headline and core CPI inflation are currently around 3.0% (six-month annualised). The FOMC’s headline PCE forecast for 2023 recognises this fact; the annual rate forecast for December 2023 is now 2.8%yr versus 3.3%yr in September. The marginal reductions to the headline PCE inflation forecasts for 2024 and 2025 (-0.1ppts to 2.4% and 2.1% respectively) point to this trend continuing and risks broadly being balanced.
The Committee remains optimistic on the structural strength of the US economy. The GDP growth forecast has been edged down by 0.1ppts in 2024 to 1.4%, but this follows a 0.5ppt upward revision to the forecast for 2023 to 2.6%yr. Growth further out is also expected to be back around trend at 1.8%yr for 2025 and 1.9%yr for 2026.
While the FOMC are comfortable labour demand and supply are coming into balance, they do not anticipate supply outpacing demand at any stage, with the unemployment rate projected to rise to 4.1% in 2024 and hold there indefinitely. Broadly, this expectation is consistent with full employment being maintained into the ‘longer run’.
During the post-meeting press conference, Chair Powell was balanced in his assessment of the risks noting that, despite the revisions to their forecasts, the Committee is willing to tighten policy further if appropriate (i.e. demand and inflation surprise materially to the upside). However, Chair Powell also recognised the risk of recession given the restrictive stance of policy and with the full effects of monetary tightening still to be felt. Late in the press conference, he also cited a belief that the Committee needed to be “reducing restriction well before 2%”.
Contrasting our own forecasts for the US economy as set out in the December/January edition of Market Outlook, (PDF 438KB) we see downside risks to the FOMC’s activity views, forecasting two years of modestly below-trend growth in 2024 and 2025 and a lift in the unemployment rate to 4.7%. However, we also expect inflation to surprise to the upside H2 2024, with a 2.5% annualised pace anticipated on average to end-2025. This anticipated imbalance between growth and inflation is a consequence of enduring capacity constraints in the housing sector and the limited breadth of the current business investment upswing – the CHIPS and Science Act and IRA incentivising rapid investment in some manufacturing sub sectors but not the entire production chain or power generation, limiting capacity and productivity gains.
These divergences support the FOMC being active in its policy easing in 2024 to preclude any further tightening in the real stance of policy as inflation slows, but to then take their time in reducing policy’s restrictiveness as the US economy battles with capacity constraints and while wage growth decelerates slowly to average levels.
The other risk to take into consideration is the impact of policy easing on term interest rates. If market rates overshoot to the downside into 2024 as they arguably did to the upside in 2023, the FOMC may need to rein in expectations of the pace and scale of easing. This is particularly the case if we are right in forecasting inflation to print above the 2.0%yr medium-term target from H2 2024. In the near term, though, lower term rates would help protect against a downside surprise to growth. The FOMC will therefore need to strike a balance here. Further out, a downside overshoot of term rates would be inconsistent with rising term premium that the US fiscal position and outlook would seem to warrant. We see the risk of rising term premium becoming more prominent from late-2025.
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