The Federal Reserve now believes it can have the best of both worlds: contain excessive inflation without pushing the economy into a recession.

Powell surprised the markets last week with his extraordinarily accommodating comments on interest rate prospects. He closed the door to further increases and strongly emphasized the possibility of rate cuts, something he had firmly rejected just two weeks earlier. The central bank governor had not accustomed us to such drastic and rapid changes. The “higher for longer” approach is now forgotten. Instead, officials expect further drops in inflation that will make earlier and faster rate cuts possible, even necessary.

The median expectation from the Fed’s economic projections summary is for three 25-basis-point interest rate reductions in 2024, ending the year 50 basis points below the September projections. The Fed might have reasons to make even more significant cuts if the economy evolves as expected, with slower growth, rising unemployment, and declining inflation. Lower inflation would automatically make any given level of short-term rates more restrictive in real terms (adjusted for inflation), requiring cuts to maintain the same monetary policy stance. As inflation decreases, the Fed might give more weight to its other mandate: maintaining maximum employment consistent with price stability. The Taylor rule, a widely used indicator of monetary policy, suggests that a central bank should loosen its monetary policy further as it approaches its inflation target.

This pivot significantly reduces the risk of a recession and a hard landing, largely due to its impact on the markets. Federal funds futures contracts already incorporate a 150-basis-point easing next year. Since late October, 10-year Treasury yields have dropped by about 90 basis points, the stock market has risen by more than 10%, credit spreads have narrowed, and the dollar has weakened.

The problem is that the central bank’s accommodative stance also increases the possibility of no landing, meaning overheating and persistent inflation that could undermine the Fed’s credibility while requiring a new tightening and a deeper recession to regain control of the situation. Many things could go wrong.

The growth slowdown observed in late 2023 could reverse in 2024, as it did a year earlier. This year’s substantial increase in labour supply may not extend into 2024, leaving the labour market too tight and wage inflation too high. The current trend of 4% is not consistent with sustainable 2% inflation.
Prices could accelerate again after transient factors, such as pandemic-driven demand for goods and supply chain disruptions, resolve. Service inflation (excluding housing) could prove more persistent than expected. What about the international context, with ongoing tensions in the Middle East, an endless war in Ukraine, and the emergence of a geopolitical entity that could reshape commodity geopolitics: BRICS.

Powell has repeatedly emphasized that the Fed must finish the job by ensuring that inflation returns to 2% and stays there. However, the more he insists on rate cuts to avoid a recession, the greater the risk of not being able to control inflation and of the markets being unpleasantly surprised.
There is a timing difference between the market’s anticipation and the Fed’s decision today. While underlying inflation is still twice the U.S. target and rates have not yet fallen, stock and bond markets have already soared. Regardless of what central bankers say, investors have already factored in a policy change and are more optimistic than a Fed that is already optimistic. Investors anticipate a 125-basis-point rate cut next year, compared to 75 basis points for the Fed.

Based on history, there is no particular reason to expect that either party is right. Both are often wrong. As stated earlier, there is still plenty of room for many twists and turns in 2024.

In this environment, The evolution of the dollar is more consensual. The United States seems more inclined to cut rates than Western European countries, while Japan will likely raise rates at some point. A cheaper dollar should support the American manufacturing industry, which tends to be heavily represented in the pivotal states of the Midwest. In a high-risk election year, this is a boon for the Democratic administration.