Source: Finance Association
Author: Xiao Xiang

At 3 a.m. Beijing time on Thursday, the Federal Reserve will announce its first interest rate decision of 2024. After entering this “year of interest rate cuts” recognized by everyone, what kind of face the Federal Reserve officials will actually look in front of the world tonight is undoubtedly drawing a lot of attention.

Despite current industry expectations, the Federal Reserve's interest rate decision has been “fixed” for the fourth time in a row — tonight it will almost certainly maintain the federal interest rate target range of 5.25%-5.5%, which was hit in July last year. However, any minor change in the Federal Reserve's monetary policy statement, as well as the hawk-dove stance revealed by Federal Reserve Chairman Powell at the post-meeting press conference, could change the market trend, which has remained chaotic since the beginning of the year.

The following are the three main points we have summarized in our outlook on tonight's US Federal Reserve decision — since this meeting does not release economic outlook reports and interest rate bitmap estimates that are only carried out at the end of every quarter, people's main focus is also expected to be on the “golden mouth” of Federal Reserve Chairman Powell and how to look forward to the future monetary policy path.

Tonight's highlights ①: Is the Federal Reserve's statement expected to change one sentence?

I believe almost everyone wants to know tonight as soon as possible when the Federal Reserve will cut interest rates during the year — in March or in the second quarter? However, in our opinion, when the Federal Reserve's monetary policy statement is first released at 3 a.m. Beijing time, this question is likely to remain a fog: because it is unlikely that the Federal Reserve will clearly state in its statement when the first interest rate cut will arrive.

But even so, everyone's eyes are expected to fall on one of the key words in the statement — many Fed observers believe that a change in this statement may completely make people break away from the Fed's austerity cycle over the past two years.

Nick Timiraos, a famous journalist known as the “New Federal Reserve News Agency,” said last weekend that the Federal Reserve may adjust its policy statement at the upcoming policy meeting to remove previous language that suggests that the next step is more likely to raise interest rates rather than cut interest rates.

Although Timiraos did not specify what this phrase was, many industry insiders have focused on a sentence that had been slightly changed in the last month's resolution: “In determining the extent to which any additional policy tightening is appropriate and if the inflation rate can return to 2% over time, the committee will consider the cumulative tightening of monetary policy, the lag in monetary policy affecting economic activity and inflation, and changes in the economic and financial situation.” (Note: The word “any” was added during the December meeting of the Federal Reserve)

Some analysts said that over the past year or so, this phrase — mainly the first half of the sentence “determines the extent to which any additional policy tightening is appropriate”, emphasized the Federal Reserve's willingness to continue to raise interest rates until the inflation target is reached.

If this half sentence is completely removed, it may indicate that it has left the door open for possible future interest rate cuts; and if the Federal Reserve keeps this phrase, the signal from policymakers may be that they are not sure what will happen in the future.

This difference will be significant for financial markets. Economists at Deutsche Bank believe that the revised wording would be equivalent to carrying out a “meaningful and thorough reform” of the FOMC post-meeting statement and its direction.

“We heard at the December meeting that further interest rate hikes are no longer the Fed's benchmark estimate,” said Matthew Luzzetti, chief US economist at Deutsche Bank. “Therefore, getting rid of this clear austerity trend will be a prerequisite so that the Fed can more actively consider when it is likely to cut interest rates, and even open the door for March interest rate cuts.”

According to statistics, at least from the end of 2022, the FOMC will use the above words or similar expressions in post-meeting statements to show the FOMC's determination to tighten monetary policy to reduce inflation. However, with the six-month and three-month annualized measurements of the core PCE price index showing that the US inflation rate is actually at or below the 2% target, this kind of hawkish rhetoric seems unnecessary now.

Bill English, the former head of monetary affairs at the Federal Reserve and a current professor of finance at Yale University School of Management, pointed out: “What Fed officials may want to do now is get lots of selectivity. This means they may say something vague at this time, such as we are determining what might be appropriate policy positions or something like that.”

Seth Carpenter, chief global economist at Morgan Stanley, said that the FOMC is likely to adjust its interest rate guidelines, abandon references to possible “tightening” interest rates, and instead only use neutral terms such as “policy position” without hawkish or dovish colors. However, most of the rest of the statement is probably similar to the statement issued in December last year.

Bank of America Global Research economist Michael Gapen and strategists Mark Cabana and Alex Cohen also pointed out that the Fed's policy interest rate guidelines need to be changed again because we believe that the trend of raising interest rates in the current statement is still untenable. The wording may become more neutral, but it will show some looseness.

Tonight's key highlights ②: How does Powell view the prospects of interest rate cuts under hot data?

Judging from the timeline, the highlights of tonight's Federal Reserve monetary policy statement will mainly focus on these subtle changes in wording. Therefore, at 3 a.m. Beijing time, the market will not necessarily fluctuate greatly. However, when Powell's press conference begins half an hour later (3:30), the climax of this Sabbath Night will officially kick off.

At the press conference, Powell is likely to be asked if the Federal Reserve is considering cutting interest rates in March, and whether the median estimate of the 75 basis point bitmap for this year's December meeting still reflects the current general views of officials.

Judging from the pricing of the interest rate market, with economic indicators such as US non-agricultural and GDP generally showing at the beginning of the new year, the probability that the Federal Reserve will cut interest rates for the first time in March has quickly dropped to less than 40% (the probability was as high as 80% at the end of last year). In other words, traders now expect May to be the window to cut interest rates for the first time, while interest rate cuts will still reach 5 or more times throughout the year.

Since Powell has hardly appeared in public since this year, tonight everyone will focus on how he will hint at the future path and intensity of interest rate cuts.

Normally, the Federal Reserve often cuts interest rates due to a sharp slowdown in economic activity. But things were different this time around: US economic growth remained surprisingly strong until the end of last year. Factors preventing the Federal Reserve from cutting interest rates soon also include that bond yields fell rapidly at the end of last year, while US stocks reached a record high at the beginning of the new year. This may boost economic activity and consumer spending.

William English, a professor at the Yale School of Management and a former senior economist at the Federal Reserve, said that for this reason, officials may not cut interest rates until May of this year or even later.

Federal Reserve Governor Waller also recently stated that after inflationary pressure dropped sharply in the second half of 2023, the Federal Reserve is “in sight” when it is close to reaching its 2% inflation target. However, he argues, strong growth and a tight labor market mean that officials need not act hastily. “I don't see any reason to support immediate action or cut interest rates as fast as in the past.”

Krishna Guha, an economist who used to be a Federal Reserve official and now works for Evercore ISI, also believes, “There has been no data showing that the US economy is at risk since the beginning of the year. If you're a policy maker at the Federal Reserve, you have plenty of choices about when to act. The benefit of starting to cut interest rates later is that you can confirm that everything is on track to sustainably return the inflation rate to 2%.”

Rick Rieder, BlackRock's chief investment officer for global fixed income and head of the company's global allocation investment team, said that the Federal Reserve “will not rush to cut interest rates”; even if the Fed opens the door to lower interest rates, it will adopt a “more neutral” stance on monetary policy. “I still think March (interest rate cut) is still early. Regarding the Federal Reserve's actions in March, I think we still need some data to show that the economy is showing a more obvious decline than it is now.”

Of course, there are now many industry insiders who support the Fed's interest rate cut in March. Goldman Sachs chief economist Jan Hatzius predicted that the Federal Reserve is likely to start cutting interest rates in March. He quoted Powell's statement at the December 13 press conference as saying that the committee hopes to cut interest rates before the inflation rate falls to 2%. Hatzius also expects to cut interest rates 5 times this year, in line with current market forecasts.

Dario Perkins, an economist at GlobalData TS Lombard in London, said, “The reason why Federal Reserve officials have aggressively raised interest rates over the past two years is because they are concerned that high inflation will cause companies and consumers to expect prices to continue to be high, thus forming a closed loop of self-realization, repeating the mistakes of the 70s of the last century. But now it's increasingly like a series of supply shocks that have caused prices in various sectors such as goods, housing, services, and labor to skyrocket one after another. It gives the impression that inflation continues to rise, which is actually not the case.”

He said, “If the terrible trend of the 70s of the last century hadn't occurred, the Fed should be able to cut interest rates soon, and there is no sign that it will appear right now. The lesson of the past 12 months is that we don't really need to experience pain to reduce inflation to an acceptable level.”

In any case, if Powell really intends to cut interest rates in March, he may reveal some telltale signs in his speech tonight; otherwise, it may indicate that he hasn't really thought it out yet or is still interested in continuing to wait and see. Guha pointed out, “I would expect that if they plan to cut interest rates in March, then we will get a pretty clear clue from Powell's statement in January. But I still think the Federal Reserve is most likely to start cutting interest rates in May or June.”

Tonight's highlights ③: What is Powell's attitude towards slowing down the downturn?

In addition to the topic of interest rate cuts, tonight's Federal Reserve resolution is also a focus of much attention from the outside world, and that is whether Powell will hint at slowing down the pace of contraction.

The minutes of the December meeting released by the Federal Reserve earlier this month show that some Fed officials believe that the pace of quantitative austerity (QT) needs to be reviewed soon. They said that the sharp decline in the use of the Federal Reserve's reverse repurchase tools may mark the beginning of the end of the period of abundant liquidity.

Coincidentally, Dallas Federal Reserve Chairman Logan also pointed out at the beginning of this year that the Federal Reserve should first slow down the pace of reducing its balance sheet and then gradually end the plan. “In the long run, slowly normalizing the balance sheet can actually help achieve a more efficient balance sheet because it allows for smooth redistribution and reduces the possibility of having to completely stop too soon.”

Since the summer of 2022, the size of its balance sheet has now dropped to about $7.7 trillion as the Federal Reserve returns to maturing securities with a monthly return of $95 billion. This QT initiative removes liquidity from the financial system, contrary to the effect of quantitative easing (QE).

However, in recent weeks, a debate that has spawned from this has also rapidly unraveled — many market participants are questioning whether the Federal Reserve has misjudged something: the extent to which it can tighten without causing chaos in the market, such as overnight repurchase agreements.

Although the current balance of bank reserves on the Fed's balance sheet is still as high as 3.48 trillion US dollars, far higher than the level when the Federal Reserve began to shrink in 2022, many market participants are still worried about the size of the reserves, which may not be as sufficient as the Fed's policymakers think. Federal Reserve officials were “taught a lesson” in 2019 — overnight market interest rates soared four times to 10%, which forced the Federal Reserve to take urgent intervention measures.

At the end of last year, high fluctuations in financing market benchmark interest rates, such as the Guaranteed Overnight Financing Rate (SOFR), which soared to record levels, caused some traders to worry that the “money shortage” might return. Meanwhile, the use of the Federal Reserve's overnight reverse repurchase tool quickly shrunk to about 577.6 billion US dollars at the beginning of the new year. The Federal Reserve's overnight reverse repurchase tool can be understood as a reservoir of idle funds for non-bank institutions. The IMF stores cash here, and at the same time, it can also act as a buffer for bank reserves.

Chris Low, chief economist at FHN Financial, said that if the pace of downsizing slows down, it will mean that the Federal Reserve needs to buy more treasury bonds, which is a dovish signal for the market.

Thomas Simons, a senior American economist at Jefferies, also believes, “They (the Federal Reserve) are getting closer to the lowest level of affordable reserves. At this point, reducing the QT scale can be said to be very appropriate.”

However, Marc Giannini, head of US research at Barclays Bank, said that no decision on balance sheet adjustments is imminent. Giannoni said in a report to clients, “We think Federal Reserve staff will submit materials to the FOMC at the upcoming meeting. FOMC participants will discuss these materials, but we expect to wait until later meetings to announce a slowdown in the pace of downsizing and the end of QT.”

editor/tolk