Fed Chair Powell made all the relevant points in his press conference. He explained that rate hikes had not been taken off the table, but were not “the base case”; he said that inflation had made progress but that continued further progress was necessary to be comfortable that the Fed was on the right track, repeating that there was “still a ways to go”. Powell also repeated the description of three stages of tightening (how fast, how high and how long), identifying the Fed as still at the second stage. However, Powell also said enough to suggest that the Fed was closer to turning on rates than the forecasts suggested. First he said that the third stage – how long and thus when to cut – was coming into view. Something that he said the Committee “did discuss today”, albeit then suggesting this was only as a topic to be discussed. He also said the Fed wanted to avoid “holding on for too long” to avoid “making that mistake” of being behind the curve again. He also stated that potential growth could have exceeded 2½% this year – something that if true and persistent could suggest continued material easing in inflation with still solid growth - before musing whether participation increases and supply-chain improvements may have run their course.
We assume that the Fed would have wanted to gently push back on market expectations of rate cuts beginning soon and sharply next year. Yet despite delivering some of the lines necessary, Powell’s broader commentary has served the opposite (see below for extent of market reaction). Accordingly, we have to assess whether this was by design or accident. We will likely see in comments from other Fed participants in the remaining days of this year and early next, and minutes later in January whether there is any attempt to reinforce a more cautious stance. We suspect that this is likely. But this now risks a more abrupt market adjustment than necessary. Our view is that the 75bps the Fed prices for next year is its current best guess of where rates should be by year-end. It is also consistent with our own view. But markets have a very different outlook, more so after today’s conference.
Indeed, market reaction has been sharp. Short-term rates moved to price more cuts, the Fed is now almost fully-priced to cut by March having moved 10bps after Powell’s conference, November’s contract now suggests rates around 4.00% (more than 5 cuts) having dropped 30bps. 2-year UST yields fell 21bps to 4.46% and 10-year dropped 13bps to 4.03%. At the same time, the dollar dropped sharply by 1% and the S&P 500 index set a new record, briefly above 4700 before retracing to be still 1% higher.
The Fed Chair finished off with a more technical question on quantitative tightening. He confirmed that rate cuts and QT are “on independent tracks” and suggested that with $3.5trn of reserves, these could still be considered ample. Powell confirmed that they were not talking about changing the pace of QT at this stage. But a more meaningful debate about how low these reserves can be taken will also arise next year.