- Fixed Income Portfolio Manager
Switzerland, Institutional
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The US Federal Reserve (Fed) kept policy rates on hold for a third consecutive time at its December 2023 policy meeting. The Fed’s updated projection materials forecast a slightly faster pace of rate cuts than the consensus expected although still fewer than is currently reflected in market pricing. During Chair Jerome Powell’s post-meeting press conference, he cautioned about the stickiness of services inflation and left some room for the possibility that another increase in policy rates could be warranted. In its updated Summary of Economic Projections (SEP), most Federal Open Market Committee participants projected 75 basis points (bps) of rate cuts in 2024 compared to 115 bps priced into fed funds futures markets just before the meeting. The Fed also lowered its growth and inflation forecasts.
What did the Fed get wrong in 2023?
Two key pieces of economic data will end the year much stronger than the Fed anticipated a year ago. The US economy is on track to grow at 2.4% in 2023, based on real GDP, well above the Fed’s initial forecast of 0.5%. And the unemployment rate ended November at 3.7% compared to the Fed’s predicted 4.6%. These results are remarkable given many prognosticators were calling for the US economy to enter recession, especially considering the regional banking sector turmoil in March that may very well have deteriorated into a crisis if not for the swift actions by policymakers (including the Fed’s Bank Term Funding Program) to restore confidence and add liquidity to the financial system. Expansionary fiscal policy and elevated home prices have also served to support consumer spending for now, though I’m skeptical that this strength will persist into 2024 and my leading indicators suggest the unemployment rate will increase from here.
Some Fed forecasts proved prescient
Core PCE inflation, the Fed’s preferred gauge, has moderated to 3.5% as of the end of October, matching the Fed’s end-of-2023 forecast from the December 2022 SEP, but is widely expected to end the year closer to 3%. While the deceleration is welcome, it would be premature for the Fed to declare victory and cut policy rates in short order. I expect core inflation to continue to move below 3% by the middle of 2024, assuming that coincides with the gradual increase in the unemployment rate I anticipate, paving the way for a pivot to easing policy rates. The Fed also came close to nailing its projection for its target fed funds rate. The central tendency — which excludes the three highest and three lowest projections — in the SEP ranged from 5.1% to 5.4% compared to the effective rate of 5.3% at this writing.
Final thoughts for Fed watchers
I don’t have strong conviction as to whether the Fed or market pricing will prove more accurate in terms of rate cuts for 2024. Certainly, policy will be less restrictive in 2024 and I expect the Fed to feel more emboldened to cut policy rates well in advance of inflation falling to its stated 2% target. While the Fed’s projections are not set in stone and will adjust to evolving economic data and financial conditions, it did an admirable job of managing policy through 2023. With more clarity that inflation pressures were attributed primarily to supply constraints as opposed to excess demand, I think the Fed should have more confidence in its projections heading into the new year, absent an exogenous shock.
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