The Fed is Not Making the Cut … Yet

Key Takeaways

• At its January meeting, the Federal Reserve’s Federal Open Market Committee (FOMC) held the federal funds target rate range at a 23-year high of 5.25% to 5.50%.
• Fed Chair Jerome Powell indicated rate cuts are not imminent due to inflation worries.
• The FOMC also added language in its January statement about interest-rate cuts, stating, “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
• Market expectations for the FOMC to hold its benchmark rate steady at the current range started the meeting at 97.9%, an 18.8% increase from the start of 2024.
• At the end of the FOMC meeting, market expectations for a rate cut in March plummeted from 73.4% at the start of January to 34.5%.
• The Fed painted a brighter picture of the U.S. economy compared to its December outlook.

At their January meeting, Federal Open Market Committee (FOMC) members unanimously agreed to leave the fed funds rate range unchanged at 5.25% to 5.50%. With inflation nearing the Fed’s 2% long-term target but the economy still growing, the central bank’s decision to keep rates steady for the fourth consecutive time was broadly expected. Estimates for rate cuts to begin at the Fed’s first meeting of 2024 started the year at 82.4%, while almost 20% of the market thought a rate cut was warranted due to the drop in inflation.

The Fed painted a much brighter picture of the U.S. economy compared to its December outlook but also underscored it was in no rush to cut the fed funds rate.

“It will likely be appropriate to begin dialing back policy restraint at some point this year, but the economy has surprised forecasters in many ways since the pandemic, and ongoing progress toward our 2% inflation objective is not assured,” Fed Chair Jerome Powell said after the meeting.

With inflation near the Fed’s 2% long-term target and recession fears at bay for now, the economy looks to be on course for a soft landing. Equity and bond markets have done well since the Fed entered this holding pattern, it has also led to the question for central bank officials about the pressures on real interest rates and when to lower nominal interest rates to prevent real rates from rising further.

In addition, the Fed decided to continue to allow up to $95 billion in assets ($60 billion in Treasury securities and $35 billion in agency-backed securities) to roll off its roughly $7.7 trillion balance sheet each month, but the current pace will be debated at the central bank’s March meeting.

Below are the Fed statement language changes from December:

Market Reaction

After the Fed announcement, the 10-year Treasury ended the day lower and finished at 3.99%; short and long rates were also lower for the day.

10-Year Treasury Yield Over the Past 12 Months

Equity markets closed in negative territory on the final day of the FOMC meeting, as the committee made it clear that it was in no rush to cut the benchmark rate. While Chair Powell stated the committee would move to cut rates should labor markets come under pressure or reductions n inflation appear to be sustainable, that was not enough to appease equity markets. Both the Dow Jones Industrial Average and S&P 500 Index finished down -0.82% and -1.61%, respectively, for the day.

In Conclusion

The first FOMC meeting of the year met market expectations by again keeping interest rates steady, but the Fed’s rhetoric also provided a keen reminder of the central bank’s determination to drive inflation back to its 2% target. While it appeared that many market participants expected the Fed to be closer to making its first cut in the fed funds rate since the hiking-cycle began, the committee made it clear rate cuts won't begin until the data supports the recent decrease in inflation is sustainable.

So, while investors have seen risk rewarded since the last time the Fed met in December (high-yield bonds, represented by Bloomberg Corporate High Yield; bank loans, represented by Morningstar LSTA; and equities, represented by Russell 3000 have been up 2.37%, 1.71% and 4.58%, respectively), the economic optimism shown by Chair Powell seemed to be overshadowed in investor’s eyes by his and the committee’s comments about the sustainability of the reduction in inflation. This also seemed to potentially signal to investors that they may need to reassess expectations of how higher-for-longer might impact company financials given a more tepid stance by the Fed on the state of inflation. But time will tell if investors remember what was said today or if they will take an out-of-sight, out-of-mind approach until the Fed’s next meeting in March.

Definitions:

The 10-year Treasury note is a debt obligation issued by the U.S. government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.

‍Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest-rate level.

The Dow Jones Industrial Average Index (DJIA) tracks the share price of the top 30 large, publicly-owned U.S. companies which is often used as an indicator of the overall condition of the U.S. stock market.

The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System that determines the direction of monetary policy.

The Fed balance sheet is a financial statement published once a week that shows what the Federal Reserve (Fed) owns and owes.

High-yield bonds (or junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.

Nominal interest rate is the interest rate before taking inflation into account, in contrast to real interest rates and effective interest rates.

Real gross domestic product (GDP) is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year.

A real interest rate is one that has been adjusted for inflation, reflecting the real cost of funds to the borrower and the real yield to the lender.

The S&P 500 index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.

A yield curve is a line that plots yields(interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.

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