The Fed’s Message To The Market Isn’t What It Seems

A lot can change in two weeks. Just two weeks ago, Jay Powell, the chairman of the FOMC, was telling the world it was premature to talk about rate cuts, and then today, the Fed’s dot plot shows three rate cuts for 2024.

The odd part is that expectations from many, myself included, were that the Fed was concerned about financial conditions easing too much and that acknowledging rate cuts would be caving into the market. The Fed’s message today seemed to be that it does not care about what the market does or thinks. Powell even mentioned the seesawing back and forth with the market and financial conditions in the press conference, noting that financial conditions will come along to where they need to be.

Perhaps that change in tune is because the Fed now feels confident in the progress inflation is making and feels better about where inflation is currently. Additionally, what seems to have been lost is that the rate cuts indicated were because the Fed is projecting lower inflation rates for next year, not because the Fed is trying to loosen policy. Rate cuts are expected as inflation rates fall because otherwise, the policy would become more restrictive and perhaps more restrictive than desired.

As a result, the Fed now sees rates at 4.6% by the end of 2024, down from previous estimates of 5.1%, while cutting its PCE forecast to 2.4%. This suggests that real rates would be at 2.2%. This would still be considered restrictive policy.

Additionally, the Fed lowered its GDP growth outlook slightly for next year to 1.4% from 1.5%, while the central tendency for the longer run rate pushed down to a range of 2.5% to 3.0% from 2.5% to 3.3%. This suggests the Fed sees the economy slowing with the real neutral interest rate at 0.50% over the long term.

This seems to propose that the Fed thinks economic data will continue to show a weakening of the economy, and the weaker data will result in markets adjusting and financial conditions tightening on their own.

Steeper Curve

But more importantly, the bond market may be saying the same thing. The Fed also is permitting the bond market for the yield curve to start to steepen now, and it’s more likely than not to happen in the form of the two-year rate falling. This already has been one of the deepest and longest inversions in decades. The fact is that typically, following inversion, this deep and long recession has followed over the past 60 years.

A steepening yield curve doesn’t cause a recession, but typically, the market begins to detect a slowdown in the economy. Once the market detects the slowdown in the economy, it anticipates more rate cuts from the Fed, which leads to the steepening process accelerating, which is part of the steepening that’s the recession signal.

Ultimately, it seems that the Fed is saying this is where we think policy is going because we think the data will uphold it. Agree or disagree, it’s up to you.