FOMC Market Shifts Anticipations: Likelihood of Rate Hike Diminishes Amidst Weaker Inflation and Labor Market Improvements

FOMC Market Shifts Anticipations: Likelihood of Rate Hike Diminishes Amidst Weaker Inflation and Labor Market Improvements 

The likelihood of a rate hike at the upcoming meeting has diminished, given the recent weaker October inflation figures and signs of improvement in the labor market. In October, the Consumer Price Index (CPI) remained unchanged, with the core CPI increasing by 0.2% month-on-month, slightly below consensus expectations. Additionally, the October core Personal Consumption Expenditures (PCE) decreased to 3.5% year-on-year, with the six-month annualized rate falling to 2.5%.

Governor Waller's comments on November 28 were pivotal, causing the market to revise its expectations for the timing and pace of rate cuts. Waller, typically considered hawkish, expressed confidence that current policy was well-positioned to slow the economy and bring inflation back to the target of 2 percent. He downplayed concerns about a reacceleration in growth and suggested the possibility of lowering the policy rate if lower inflation persists.

The market reacted strongly to Waller's comments, leading to a significant drop in front-end yields as rate cuts were brought forward to the May 2024 meeting, accompanied by an easing of financial conditions. However, some Fed officials, including Chair Powell and NY Fed President Williams, pushed back against discussions of easing policy, emphasizing the need for caution.

Yields retraced slightly after a robust November jobs report, as the market unwound some of the previously priced-in aggressive rate cuts for the next year. The focus of the upcoming meeting, with rates expected to remain unchanged, will be on forward guidance through the policy statement, updated Summary of Economic Projections (SEPs), and Powell's post-meeting press conference.

The 2024 dot plot, which represents the Fed's interest rate projections, is a key element of anticipation. The 2023 dot is expected to be revised down to 5.4%, indicating a more dovish stance, while the 2024 dot may move lower, possibly to 4.875% or even 4.625%, reflecting progress on inflation. Different scenarios for the 2024 dot have been outlined, with varying probabilities assigned by banks, suggesting potential market reactions based on these outcomes.

The SEPs are anticipated to show a higher growth estimate for 2023, reflecting current conditions after a strong Q3. The core PCE projection for 2023 is expected to be revised down to 3.5%, while 2024 inflation may fall to 2.4-2.5%. The policy statement is likely to maintain a tightening bias, but there may be adjustments in the language regarding the extent of additional policy firming.

Chair Powell's press conference is expected to echo his recent comments, emphasizing that policy rates are now restrictive and indicating a shift in discussions toward the duration of a restrictive stance. The administered rates are currently in the range of 5.25-5.50%, with the spread between the reverse repo rate (RRP) and interest on reserves (IOR) expected to remain steady at 10 basis points.

Regarding the balance sheet, no changes are expected in policy, and discussions around the end of Quantitative Tightening (QT) are ongoing. The market currently prices in unchanged rates for the upcoming meeting, with around a 37% chance of a rate cut in March and over 100 basis points of rate cuts priced by the end of 2024.