Fed set to hold rates as market looks for hints of cuts ahead

The Federal Reserve is unlikely to declare victory in its nearly two-year battle against inflation this week. Still, the central bank's chairman may indicate for the first time that lower interest rates are near.

Inflation growth is dipping toward the Fed's 2% goal, the domestic jobs market remains relatively robust and US economic activity continues to grow, boosting the odds that a recession can be avoided, a soft landing achieved and a series of rate cuts can soon begin.

The Fed hiked its benchmark federal funds rate by 25 basis points (bps) in July 2023 and has not altered rates since, triggering the expected peak of a monetary policy odyssey that included 525 bps worth of hikes, bringing rates to heights not seen since 2001. While the statement out of the Jan. 31 meeting will likely avoid fueling speculation over when potential rate cuts will begin, the market will be closely following Fed Chairman Jerome Powell's remarks to the press for hints on policy timing.

"Powell will likely signal rate cuts later this year if the economy and inflation maintain their current course," said Oren Klachkin, a financial market economist at Nationwide. "Basically, they want to see more evidence that their restrictive policy stance is having its intended consequences."

Cuts on the horizon

It is a near certainty that Fed officials will again opt not to alter rates at their meeting this week, but it could be the last meeting for a while that does not end in a rate change.

As of Jan. 29, the futures market had about 50% odds of the first rate cut taking place at the Fed's March meeting and roughly 90% odds that at least one cut will take place by the Fed's May meeting, according to the CME FedWatch Tool.

How soon the Fed decides to cut rates ultimately hinges on how satisfied central bank officials are with inflation's downward progress. Personal consumption expenditures (PCE) excluding food and energy, known as "core" PCE and the Fed's preferred inflation metric, increased 2.9% from December 2022 to December 2023, the lowest rate of annual growth since March 2021, the Bureau of Economic Analysis reported Jan. 26.

"Any discussion of rate cuts will be intrinsically linked to positive developments in inflation metrics, and rate cut discussions will be mechanically tied to encouraging developments on the inflation front," said Gregory Daco, chief economist at EY-Parthenon, Ernst & Young.

Rate cuts will likely be the main topic of this week's Fed meeting, but the market may be forecasting rate cuts taking place too early and too rapidly, said Daco, who expects 100 bps worth of cuts in 2024, with 25 bps cuts approved in May, June, September and December.

"But a less inflationary or recessionary environment could favor the Fed front-loading and speeding up rate cuts," Daco said.

With GDP for the fourth quarter rising again and December 2023 inflation data showing a continued downward trend, there is a "decent chance" that Powell will hint at a March cut this week, said Patrick Horan, a research fellow at the Mercatus Center at George Mason University.

"Assuming forecasts of continued disinflation are roughly right, the odds of a rate cut in either March or May are very high," Horan said.

Global cuts wait

This week's Fed meeting takes place as central banks worldwide have put their monetary policies on hold in advance of a first rate cut. On Jan. 25, the European Central Bank kept its policy rate and forward guidance unchanged, while the Bank of Canada on Jan. 24 held its target for the overnight rate at 5% for the fourth consecutive meeting. The Bank of England is expected to leave interest rates at 5.25% at its Feb. 1 monetary policy meeting.

The rest of the world may be waiting for the Fed to move first on cuts, but rather than a sign of incoming policy loosening, Powell and other Fed officials may stress that cuts are not imminent and that policy hikes remain a possibility, said James Knightley, chief international economist with ING.

"The economy is still growing quite strongly, the labor market is tight, and inflation for now remains well above 2%," Knightley said. Fed officials "may well outline the instance in which another interest rate hike is possible — ongoing payrolls gains and rising wages, which keeps the economy stronger for longer and generates a more elevated path for inflation."