What’s happened?

The Federal Reserve (Fed, the central bank) kept its policy rate on hold at its meeting on December 12th-13th, at a target range of 5.25-5.5%. However, it has softened its outlook for interest rates, anticipating no more increases (one previously) and three rate cuts by end-2024 (two previously). In response, financial markets have priced in a more rapid easing cycle than we think is likely in 2024.

Why does it matter?

The Fed’s December meeting made a clear shift away from its hawkish messaging of recent months. The Fed chairman, Jerome Powell, stressed that a return to 2% inflation was far from guaranteed, which fits with our view that the Fed will continue to move cautiously in 2024. However, he also highlighted a clearer disinflationary trend and signs of a moderation in GDP growth since October. Further tightening is still an option, but this would require a notable acceleration in inflation from current levels, which we consider unlikely. Inflation risks related to the tight US labour market and geopolitical conflicts will persist, but we expect inflation to continue to ease gradually over 2024.

Notably, the Fed’s outlook for more modest inflation and lower interest rates compared with its September meeting was not accompanied by a downgrade of its growth and employment forecasts. Markets have interpreted this as a sign that the economy is heading for a soft landing. Stock prices are likely to continue rising and bond yields may soften further in the near term. However, we believe that financial markets’ expectations for more aggressive easing starting in April are probably overblown, and will ease back slightly in the coming weeks.

There are risks to the outlook, notably if inflation does not continue to ease with minimal impact on employment, as the Fed assumes. We also forecast a soft landing, but we have a slightly lower GDP forecast (1% in 2024, compared with the Fed’s 1.4%) and slightly higher unemployment figures (4.4%, compared with the Fed’s 4.1%). We base these on the assumption that the full impact of interest-rate tightening thus far has yet to be felt. Overall, the economy is likely to weather this change well, but there are weak points—notably, consumption among low-income and more indebted households, and troubled commercial property loans—that are likely to soften further in 2024.

What next?

Mr Powell was clearer than he has been thus far that the Fed will start cutting rates before inflation hits 2%. On this basis, we now expect the Fed to start cutting rates in the second quarter (from the third quarter previously), and to cut by a total of 75 basis points by end-2024 (50 basis points previously).

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