The inflation rate is stubbornly high above the target level, with an economic growth rate of about 3% and a strong labor market. Overall, this seems to be a perfect reason for the Federal Reserve to raise rates or at least keep them stable. However, when the Federal Open Market Committee announces its policy decision on Wednesday, it may not be the case.

Conversely, futures market traders are almost certain that the FOMC will announce a 25 basis point rate cut, which would lower its target range to 4.25% to 4.5%.

Even with the market highly anticipating this decision, it may be subject to unusually strict scrutiny. Foreign media found that while 93% of respondents expect a rate cut, only 63% believe that cutting rates is the right course of action.

Former Kansas City Federal Reserve Bank President George said in an interview on Tuesday: "I tend to lean towards 'no rate cut'. Let's see how the data turns out. A 25 basis point change usually doesn't affect our current situation, but I do think it's time to signal to the market and the public that they are not ignoring the inflation issue."

Inflation is indeed still a tricky issue facing decision-makers. While the annual inflation rate has significantly dropped from a 40-year peak in mid-2022, it has hovered between 2.5% to 3% for most of 2024. The Federal Reserve has set its inflation target at 2%.

It is expected that the Department of Commerce will announce on Friday that the Federal Reserve's preferred inflation indicator—the Personal Consumption Expenditures Price Index—rose to 2.5% in November, with the core index excluding food and Energy at 2.9%.

In this environment, to justify the reasonableness of interest rate cuts, communication will need to be skillfully managed by Chairman Powell and the committee. George stated: "They are very clear about their goals, and as inflation data is released, we see that inflation rates have not continued to decline as they did previously. Therefore, I believe we have reason to remain cautious and seriously consider how much policy easing is needed to get the economy back on track."

Federal Reserve officials supporting interest rate cuts have stated that in the current environment, policies do not need to be so strict, and they do not want to risk harming the labor market.

The possibility of "hawkish rate cuts."

If the Federal Reserve insists on cutting interest rates, then since September, the federal funds rate will have been lowered by a full percentage point.

Although this is quite a significant easing in the short term, Federal Reserve officials have some tools to let the market know that future interest rate cuts will not be so easy.

One of the tools is the dot plot matrix, which contains members' expectations for interest rates in the coming years. This matrix will be updated on Wednesday along with the rest of the Economic Projections Summary, which includes informal forecasts for inflation, unemployment, and Gross Domestic Product.

Another tool is to use guidelines in the post-meeting statement to indicate the committee's views on the direction of policy. Finally, Powell can provide further clues during a press conference.

What the market will pay closest attention to will be Powell's dialogue with the media, followed by the dot plot. Powell recently stated that in the "strong" economy he described, the Federal Reserve "can consider easing the pace of policy more cautiously."

The chief economist of Bank of New York Mellon and former director of the Federal Reserve's monetary affairs division, Reinhart, stated: "We will see their tendency to take action and start raising inflation expectations. The dot plot will slightly move upwards, and ultimately, a hawkish cut will occur."

Other actions that are about to be taken.

Most Wall Street forecasters believe that Federal Reserve officials will raise their inflation expectations for 2025 and lower their expectations for interest rate cuts.

When the dot plot was updated in September, officials indicated that there would be a 4-quarter point cut next year. According to the CME Group's FedWatch Index, the market has already lowered its expectations for easing policies, anticipating two rate cuts in 2025 after a rate cut this week.

The Federal Reserve may also skip the January meeting. Wall Street expects no significant changes in the post-meeting statement.

Officials may also raise their expectations for the "neutral" interest rate, which neither stimulates nor suppresses economic growth. This level has remained around 2.5% for many years—2% inflation rate plus 0.5% natural rate level—but has been slowly rising in recent months and could exceed 3% in the upcoming update.

Finally, given that the federal funds rate is close to the lower bound of the target range, the committee may raise its overnight reverse repurchase agreement rate by 0.05 percentage points. The "ON RPP" rate is the lowest level of the funds rate, currently at 4.55%, while the actual funds rate is at 4.58%. The minutes from the November Federal Open Market Committee meeting show that officials are considering a "technical adjustment" to the rates.

Editor/Rocky