The Federal Reserve is heading into a pivotal week, with investors laser focused on Wednesday’s interest rate decision as the central bank looks to strike a delicate balance in its fight against stubborn inflation.
A torrent of economic data has painted a mixed picture on the health of the economy heading into the meeting. While job growth and consumer spending have remained resilient, manufacturing activity has weakened and inflation shows signs of moderating. The Fed must weigh these crosscurrents as it decides whether to downshift the pace of rate hikes or stay the course with another large increase.
Fed Widely Expected to Slow Rate Hike Pace
Financial markets largely expect the Fed to deliver a 25 basis point rate hike at this week’s policy gathering. This would be a step down from the 50 basis point move in December and four consecutive 75 basis point hikes earlier last year.
Fed Funds Futures Implied Probabilities
| Rate Hike | Probability |
|---|---|
| 25 basis points | 76.0% |
| 50 basis points | 24.0% |
Data source: CME FedWatch Tool, 1/29/2024
Market expectations for a smaller hike have grown over recent weeks amid signs of moderating price pressures. The personal consumption expenditures price index, the Fed’s preferred inflation gauge, rose 5.5% in November from a year earlier – down from a recent peak of 7.3% in June 2022. Gasoline prices have also fallen sharply, providing some relief to consumers.
Still, Fed officials have been adamant that rates need to remain restrictive for some time to bring inflation back down to the 2% target. Most policymakers penciled in rates above 5% this year in their December projections. This suggests the Fed could hike a few more times, albeit in smaller increments, before stopping.
“I expect the Fed to slow the pace to 25 basis points while stressing that rates will still need to move higher and remain elevated for a while to ensure inflation continues to fall,” said Robert Frick, corporate economist at Navy Federal Credit Union.
Focus Shifts to Policy Guidance, Economic Projections
While the rate decision will be critical, attention will also turn to the Fed’s updated economic forecasts and clarity around future policy moves.
Markets want to know how high the Fed is prepared to raise rates this year and how long it might keep policy restrictive before cutting again. The dot plot of individual policymaker projections for interest rates will provide key insights.
There also may be crucial signals from Fed Chair Jerome Powell on whether the central bank is considering a pause in rate hikes or if more tightening is forthcoming.
“The language used by Powell in the post-meeting press conference will be the main event,” said analysts at TD Securities. “We look for him to leave the door open to additional hikes rather than explicitly guiding towards a pause.”
Any hints at a swift policy pivot could spark sharp moves in financial markets. Stocks and bonds have rallied in recent weeks partly on hopes that the Fed may soon stop tightening financial conditions.
Mixed Economic Picture Complicates Fed Messaging
A barrage of data has portrayed an economy that remains resilient but potentially starting to buckle under the strain of substantially higher interest rates.
Job growth blew past expectations in December, with employers adding a staggering 517,000 positions. Wages also rose strongly last month, underscoring the tight labor market conditions.
However, manufacturing activity has slowed noticeably amid softening demand. The Institute for Supply Management’s manufacturing index dropped to 48.4 in December, signaling a contraction in factory activity for the first time since May 2020.
At the same time, consumers continue spending at a healthy clip even with high inflation and rising borrowing costs. Retail sales increased more than expected in December, boosted by strong motor vehicle sales.
“The conflicting signals will make messaging tricky for Powell as he seeks to convey that rates need to remain high while also avoiding sounding hawkish given fragile sentiment,” said analysts at Oxford Economics.
The mixed data makes it less likely the Fed will explicitly guide to a pause in rate hikes anytime soon. But it also means additional large hikes appear off the table.
“We look for Powell to stress that ongoing increases are needed while rates remain stimulative, but recognize that the time for dialing back the size of hikes has come,” said Michael Gregory, Deputy Chief Economist at BMO Capital Markets.
Further Rate Hikes Could Spark Recession Fears
Most economists expect the Fed to continue hiking over the next couple meetings until reaching a terminal rate around 5% to 5.25% by mid-2023. But additional tightening risks tipping the economy into recession later this year.
Higher rates will filter through to consumers and businesses over coming months, weighing on demand. At the same time, the lagged impacts of the Fed’s rapid tightening cycle last year have yet to be fully felt. This could prompt companies to pull back on hiring plans.
“The Fed is attacking the economy with rate hikes the way antibiotics attack infections – there is a time delay before the full effects are evident,” said Bill Adams, Comerica Bank’s Chief Economist. “The Fed’s rate hikes should bear down increasingly hard on growth over the first half of 2023.”
There are already some warning signs in the housing market with existing home sales down 34% in December from the prior year amid sharply higher mortgage rates and weakening affordability.
Mortgage Rates
Chart source: Freddie Mac Primary Mortgage Market Survey, 1/26/2024
This slump along with signs of manufacturing and consumer spending slowing point to recession risk on the rise, especially if the Fed overtightens. Powell has admitted there is only so much officials can do against inflation without imposing significant costs.
“Fed tightening can’t forestall some economic pain,” said Sarah House, Senior Economist at Wells Fargo.
Markets Brace for Volatility Around Fed Decision
It will likely be another volatile week for financial markets with the Fed back in the spotlight. Stocks slid Friday amid month-end portfolio rebalancing, ending a four-week winning streak. But the major indexes remain near their highest levels since last summer after a furious rally to start 2023.
Investors have piled back into equities in anticipation of an imminent Fed pivot. But optimism over a potential pause in rate hikes could quickly fade if Powell signals more tightening ahead.
“Chair Powell will likely have to throw some cold water on market expectations,” said analysts at Barclays. “We see risks titled to a hawkish outcome that could indicate additional rate hikes.”
Treasury yields have also declined substantially since mid-November, helping drive the equity rebound. The 10-year yield dipped below 3.5% last week for the first time since September. Further bond market rallies could reverse if policymakers impress the need to keep rates higher for longer.
Beyond the Fed, volatility could also flare around a heavy week of Big Tech earnings. Apple, Amazon and Google-parent Alphabet are all set to report, providing critical glimpses into consumer spending and digital ad demand.
So it may be another choppy week for Wall Street. Expect outsized market swings around the Fed decision and tech results.
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