March FOMC Preview: The Fed Is Likely to Raise Neutral Rate Estimate and Consider Scaling Back On QT

The Federal Open Market Committee is again widely anticipated to maintain the current range of its federal funds rate target between 5.25% and 5.5%. Investors will focus on the Summary of Economic Projections and dot plots released at this meeting.

The statement from the Federal Open Market Committee is expected to be released at 2 pm Eastern Time on Wednesday, after the end of their two-day meeting, followed by a press conference with Chair Jerome Powell scheduled for 2:30 pm ET.

The recent release of inflation data is unlikely to instill confidence in the Federal Reserve to proceed with immediate interest rate cuts. CPI and PPI for February ran hot, despite moderation in some components that drove January’s upside surprise.

Some FOMC officials have also cautioned that while inflation has slowed, it remains elevated, and the pace at which it has slowed in recent months has not been as impressive as it was in 2023.

The job market remains resilient. The US added 275K jobs in February 2024, beating forecasts of 200K and higher than a downwardly revised 229K in January. Job gains occurred in health care (67K), government (52K), and food services and drinking places (42K).

Markets are hoping for confirmation of their outlook from the updated Summary of Economic Projections or from Powell's press conference, particularly if the median expectation shifts for the number of 25-basis point rate decreases this year from the three cuts to a 4.6% median rate seen in the December update.

“If it stays at three [cuts], that's probably a pretty healthy sign that the Fed is ready to cut this summer,” suggests Maulik Bhansali, a senior portfolio manager and co-leader of the core fixed income team at Allspring Global Investments.

Nevertheless, Bhansali warns that given the recent slowdown in the progress toward curbing inflation, investors might want to brace themselves for the possibility that the dot plot forecasts just two rate reductions. Echoing this sentiment, Bank of America's analyst, U.S. economist Michael Gapen, anticipates that the forecast will stay at three cuts but acknowledges a "clear risk" that it might be reduced, as noted in a research brief issued on Friday.

At J.P. Morgan, Michael Feroli, the chief economist for the U.S., believes there's a greater than 50% chance that the Fed will indicate only two rate reductions for the year. "The December dot plot suggests it wouldn't take much for the projection to shift from three anticipated cuts this year down to two," he noted in his Friday report.

Certain members of the rate-setting committee, such as Raphael Bostic, the president of the Federal Reserve Bank of Atlanta, have expressed a preference for fewer rate cuts than the widely anticipated three reductions.

Another important consideration for the year ahead is the potential reluctance of the Federal Reserve to adjust interest rates close to a Presidential election, in order to maintain its image of political neutrality. With this in mind, the central bank might be eyeing a narrow opportunity – specifically this summer – to make any modifications to interest rates. Afterward, it may enter an informal "quiet period" until the December meeting, barring any significant shifts in economic indicators.

Economists are also alert for any change to the Fed's longer-run forecast for the funds rate, which was 2.5% in December. For instance, Feroli believes that this target rate might be adjusted upward to 2.625% or even 2.750%. This potential hike is attributed to the unexpected durability of the U.S. economy in the face of the Fed's most forceful sequence of rate hikes in its history.

"The long-term interest rate has been set at 2.5% for an extended period, yet we've heard some indications that there might be room for a slight increase," mentions Maulik Bhansali. "Should there be any indication that the long-term rate is on the upward trajectory, it would have consequences for the longer-term interest rates, such as those for 5-year [or] 10-year bonds, which hold greater significance for the economy."

Bhansali further clarifies that a higher long-term rate would affect the Fed's capacity to lower interest rates in the future: "If the rate is set above 2.5%, then there's less margin for rate reductions to reach a neutral stance." For market participants,“it probably means more to watch what the longer-run rate is doing than what happens this year.”

Adjustments to inflation and growth expectations will also be closely watched after being revised lower in the December update. In that December projection, as inflationary pressures began to ease, the Fed's median estimate anticipated the economy growing at 1.4% in 2024, a deceleration compared to the 3.2% expansion recorded in the final quarter of 2023. As measured by the Fed’s preferred indicator, the Personal Consumption Expenditure Price Index, inflation was forecast to fall to a 2.4% rate for 2024, both with and without volatile food and energy costs factored in.

Jefferies, in a recent analysis, suggested that the economic projections are unlikely to see significant alterations. "Inflation remained persistently high in January and February, yet there's nothing in the current data that justifies a revision to the year-end forecast for inflation to be higher," the note stated.

However,economists from Bank of America are predicting that the Fed might revise its economic growth prediction upwards to 1.8%, adjust its inflation forecast to 2.5%, and maintain its unemployment projections without change.

Along with rate increases, the FOMC has suggested that it will begin a discussion of when and how to slow its securities holdings drawdown at this week's meeting. Officials have said that continuing to sell securities, albeit at a slower pace, while simultaneously cutting rates would not conflict with each other.

Although there's a chance Fed officials will hold preliminary discussions on QT in March, Bloomberg still expects a formal announcement at the next meeting, in May. EY-Parthenon analyst Gregory Daco noted in his latest report that “Powell will likely refrain from providing specifics on the implementation process. We do not anticipate the tapering will start before H2 2024.”