The Federal Reserve may not close the door on interest rate cuts in March

The biggest issue facing the Federal Reserve at this week's policy meeting is what kind of smoke signal Fed Chairman Powell will send about the possibility of a rate cut at the March meeting.

Economists expect that Fed officials will not make any changes to interest rates at the January 30-31 meeting, but will use this discussion to prepare for future monetary easing.

Fed observers unanimously believe that Powell will take action in March at the earliest, but officials will not make commitments as there are still two months until the meeting. Currently, the market estimates a 50% chance of a rate cut in March.

"If I were in his position, I would basically maintain the current expectations for rate cuts." David Wilcox, former senior official of the Federal Reserve and senior researcher at Peterson Institute for International Economics and economist at Bloomberg Economics (BI), said: "In my opinion, there is a 50% chance of a rate cut in March."

Wilcox said that if all possibilities are equal for the next steps by the Fed, they could take any action depending on data.

Matthew Luzzetti, Chief U.S. Economist at Deutsche Bank, said that he expects the Fed to remove wording suggesting that their next move might be an interest rate hike from their statement to pave way for its first rate cut cycle.

This essentially means an end to tightening cycles starting from March 2022. Due to inflation concerns, previously benchmark rates were raised from near-zero levels to a range between 5.25% and 5.5%.

Given recent U.S. data, Powell will be able to provide positive assessments on prospects and discuss possibilities of long-awaited soft landing (sustained economic growth with slowing inflation).

 

The dilemma faced by The Federal Reserve: pace and endpoint of rate cuts

 

Wilcox stated that there are clear reasons for interest rate cuts by The Federal Reserve. Given progress made since last summer in reducing inflationary pressures high-interest rates are no longer needed. According to the Fed's most favored indicator, core inflation is at 2.9%, the lowest level since March 2021.

"Struggling to bring down inflation rate to 2% has almost been won, and may even be completely won," said Wilcox.

Another reason for rate cuts is that The Federal Reserve may not want financial conditions to tighten unnecessarily and trigger an economic downturn. "They want to avoid putting the economy into a recession that isn't necessary for controlling inflation," he said.

According to Wilcox, the trickier question is the pace of rate cuts and where they will stop. He expects The Federal Reserve to cut rates for the first time in March and a total of six times this year.

Michael Gapen, Chief U.S. Economist at Barclays Securities, expects The Federal Reserve to start cutting rates four times from March onwards.

"We believe that The Federal Reserve's pace of interest rate cuts will be early but gradual," says Gapen. He believes that when rates reach 3%, The Federal Reserve will stop cutting them, but it remains an unanswered debate.

Based on expectations of mild recession, Luzzetti from Deutsche Bank stated that he expects The Federal Reserve to wait until June before starting rate cuts with a total reduction of 175 basis points remaining this year.

Carl Riccadonna, Chief U.S. Economist at French bank BNP Paribas, believes that The Federal Reserve will delay its rate cut until May with further risks of postponement.

"We expect officials to remain patient before their first interest-rate cut." He noted strong growth in Q4 and high consumer confidence suggesting road towards reaching a 2% inflation target could be "rockier than expected."

At this week's press conference Powell might echo comments made by Fed Governor Waller who said rates can and should be lowered gradually and cautiously." Waller pointed out that historically when there have been threats to the economy or recession, The Federal Reserve has implemented loose policies more quickly.

 

Changes in Quantitative Tightening (QT) plan?

 

Economists are also concerned about how The Federal Reserve will discuss its policy of reducing its balance sheet. Its balance sheet size soared from $4.2 trillion in 2019 to a peak of around $9 trillion before falling back to around $7.7 trillion at the end of last year.

After the December meeting, officials began discussing the possibility of slowing down the pace of balance sheet reduction. Economists now expect more details to be announced after this week's meeting.

Chris Low, Chief Economist at FHN Financial, said that slowing down the pace of balance sheet reduction means that The Federal Reserve will need to buy more government bonds, which is seen as a dovish signal for markets.

Marc Giannini, Head U.S. Research Director at Barclays Bank, believes that any decision regarding adjustments to their balance sheet won't be imminent.

Giannoni stated in the report to clients, "We believe that Federal Reserve staff will submit materials to the FOMC at the upcoming meeting, and FOMC participants will discuss these materials. However, we expect that it will be announced at a later meeting to slow down the pace of balance sheet reduction and end QT."

 

 

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