At the December meeting, the Federal Reserve Open Market Committee held the Fed funds rate steady at 5.25-5.50%, where it’s stood since July. There were no dissents. 

The formal statement was minimally changed with a notation that economic growth ‘has slowed’ from its strong pace in the third quarter, and that inflation ‘has eased over the past year’ while remaining elevated. The word ‘any’ was inserted prior to the potential for additional policy firming, which appears minimal, but appears a clue to the reduced chances of future hikes. The Fed’s Summary of Economic Projections document showed a lower path of Fed funds by several tenths each in 2023 (5.4%), 2024 (4.6%), 2025 (3.6%), while 2026 was held steady at 2.9%, as was the longer-run path at 2.5%. 

Part of the rationale for holding rates steady at recent meetings has been the ‘tightening’ effect of rising long-term yields. But, since late October, the 10-year U.S. Treasury yield has fallen from 5.0% at its peak down to as low as 4.1%, along with some falling inflation data and policy expectations. Just as high and rising long-term rates do some of the Fed’s work in tightening policy, falling yields work against it by effectively ‘easing’ conditions. 

Based on CME Fed funds futures just before the meeting, holding steady was predicted at a probability of over 98%, with 2% for a slight hike. Chances of a -0.25% cut represent the base case by May 2024, while odds for December 2024 point to 4.00-4.25%. The key evolution in futures markets has been the likelihood of a fairly long pause, and less extreme cuts during the year as recession risks fade. Market focus has moved from this year to next year’s policy choices, including the length of time staying paused around peak levels and the severity of conditions under which the Fed would consider rate cuts. Interestingly, in Europe, the assumed lower path of policy rates from today’s 4.0% has accelerated from 3.5% to now around 3.0% by mid-2024, in keeping with collapsing inflation, deteriorating sentiment, and the economy slowing into recession.  

Economy. U.S. economic growth for Q3 came in at a revised 5.2%, far surpassing expectations—not an environment where easing would seem to be needed. However, growth is expected to decelerate sharply in Q4, shown by the Atlanta Fed’s GDPNow tool that predicts 1.2%. While not catastrophic, activity now lags the long-term trend growth rate of 1.5-2.0%. The Fed’s projections noted an increase in 2023 GDP from 2.1% to 2.6%, while it was little changed for the next few years of 2024 (1.4%, down -0.1%), 2025 (1.8%), 2026 (1.9%, up 0.1%), and longer-run unchanged at 1.8%. The consumer hasn’t fallen off a cliff yet, despite excess savings shrinking by some measures, along with rising credit balances, particularly for the bottom half of the household income distribution. Next year may provide more clarity into the shift away from hyperspending. Data continues to show manufacturing activity steady in the range of minor slowdown, while the larger services sector has also flattened in the zone of minor expansion. Changes in either of these trends could mean the difference between recession and no recession in 2024. 

Inflation. This focus of Fed concerns remains elevated, with November trailing 12-month CPI having come in yesterday at 3.1% and 4.0% for headline and core (ex-food and energy), respectively, and little changed from the prior month. The Fed’s preferred core PCE measure came in at 3.5% for the trailing year ending in October, and 2.4% at an annualized rate over the last three months. The Fed projections for Core PCE fell back by -0.5% to 3.2% in 2023, by -0.2% in 2024 to 2.4%, and -0.1% in 2025 to 2.2%. There is still room for improvement, but fears of another spike in prices have faded, with the general consensus that inflation should continue to decelerate toward normal/target levels over the next year or two. 

Employment. An area of strength in the economy continues to be labor, with the unemployment rate falling by a few tenths to 3.7% in November (surprising many economists). In the Fed’s projections, this rate was unchanged for 2023 (3.8%), 2024 and 2025 (4.1%), while 2026 notched up a tenth to 4.1%, as was the longer-run projection. There has been some debate over seasonal distortions in data resulting from the pandemic’s extreme readings, but absent that, conditions haven’t largely deteriorated. Layoffs have been minimal in most industries, other than some segments of technology, while worker power has taken the form of more frequent labor strikes for better wages and conditions. Those don’t tend to happen in weak job markets. Wage growth remains sticky also, which has kept central bankers from declaring victory over inflation too soon. Pessimists would say that the ‘Sahm Rule,’ a formula created by a former Fed economist and based on lows in the past year’s unemployment rate versus an average of recent months—and which features a strong predictive track record for recessions—has been close to the point of triggering (but hasn’t yet). 

The economy and markets have been slowly digesting the 5%+ in rate hikes since March 2022, with the last 1% of these happening earlier this year between February and July. With some hiccups, the broader economy has been able to absorb higher rates, although this adjustment remains ‘in process.’ Potential pitfalls still lie ahead, including corporate (and government) debt refinancings coming due over the next several years, in addition to challenges in commercial and residential real estate. Then again, if rates do fall, as futures markets predict, some of that high-rate pressure will naturally be relieved as well. 

Financial markets look to the future more than staying mired in the present. This explains the more extreme reactions around economic data points in a return to ‘bad news is good news’—with the assumption that weaker data raises the chances of Fed rate cuts. This is in addition to the word-by-word analysis of Fed ‘hints’ given in speeches. Thus, central bank overcommunication compared to decades past has been a mixed blessing. Broadly, conditions in the U.S. remain stronger than in many other regions of the world, such as Europe and parts of Asia, which explains why rate cuts elsewhere could be closer to realization and/or already started. Investing during recessions has historically been fruitful, as such periods are characterized by high levels of pessimism, in keeping with historically-low valuations seen today in international markets. Fixed income is another obvious beneficiary as central banks cut short-term rates and/or markets begin to lower long-term rates on their own. While a favorite today, cash loses its luster when short-term rates fall, so extreme hoarding into that asset class could ultimately be on borrowed time.