[Analysis] Fed's Attitude Shift Rate Hike Ending and Interest Rate Cut Expected

On Wednesday, all three major US stock indices closed higher, with the Dow Jones rising 500 points to hit a historic high. Both the US dollar and bond yields fell, while spot gold rose by 1.3% and broke through the $2,000 barrier once again.

The likely reason for the market's excitement was actually the hot topic of recent times: interest rate cuts!

In this context, let's interpret what the Federal Reserve's FOMC meeting on Wednesday said and how it boosted investor sentiment.

The Federal Reserve has hinted that interest rate cuts could be on the way

1. One of the factors for the interest rate cut: CPI data as expected

The Consumer Price Index (CPI), a closely watched inflation gauge, was finally released on December 12th, which was the same day as the FOMC meeting. In November, CPI rose by 3.1% from a year ago, which was slightly lower than the previous month's increase of 3.2%. Excluding volatile food and energy prices, the core CPI rose by 4% year-on-year.

The CPI data met market expectations, which provided further support for the Fed's decision to remain unchanged at the FOMC meeting.

2. Another factor for the interest rate cut: Cooling of the labor market

In our latest analysis, "[Insights for Dec. 2023] How Tightened Financial Conditions May Affect The Fed's Monetary Policy" we noted that while the labor market has shown some resilience in 2023, job growth has slowed significantly.

The release of three employment reports in December provides some clues:

• The latest Job Openings and Labor Turnover Summary (JOLTS) shows that job vacancies decreased to 8.733 million in October, which is lower than the expected 9.3 million. This represents the lowest level of job vacancies in two and a half years.

• ADP's non-farm private employment increased by 103,000 jobs in November, which is slightly slower than the 106,000 new jobs added in October. This was also lower than the expected 130,000, marking the second smallest monthly increase since January 2021.

• The non-farm payroll report showed that after seasonal adjustments, the number of non-farm jobs increased by 199,000 in November, which is slightly better than the Dow Jones' expected 190,000, and ahead of October's 150,000. Due to a slight increase in labor force participation, the unemployment rate fell to 3.7%, which is lower than the expected 3.9%.

Although two of the three data points showed a slowdown in employment, while one showed employment still growing faster than expected, the market recognizes that the job market is steadily recovering compared to the previous two years. The slightly higher-than-expected non-farm payroll data did not change the stock market's optimistic expectations, as many investors still believe that the Fed will cut interest rates next year.

FOMC Meeting Seems to Have Ignited Market Optimism

As expected, the Federal Reserve decided to maintain its key interest rate at its 2022 high point during its final meeting of the year in 2023. This is the third time this year that the Fed has kept its interest rate stable.

After the meeting, Fed Chairman Jerome Powell reported in a press conference that inflation had decreased from its peak and that unemployment had not significantly increased, which is excellent news. When asked about interest rate cuts, Powell explained that it was still too early to declare victory but officials were discussing potential interest rate cuts.

In summary, Jerome Powell's mention of "discussing interest rate cuts" for the first time was perceived as an optimistic and positive signal by investors.

In addition to the Federal Reserve's statement, they released their 2024 economic forecast report which was highly anticipated by the market. The dot plot in the report indicates that all Federal Reserve officials believe that this round of "the strongest and fastest" rate hikes has already come to an end.

Moreover, the dot plot provides a further gift as most Federal Reserve officials plan to cut interest rates as many as three times next year. This news should be seen as a reassuring sign for investors who have been eagerly waiting for interest rate cuts.

FOMC participants’ assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate

The news indicating the potential for "rate hike ending and interest rate cut expected" generated cheers from investors and led to a rise in Wall Street stock markets. All three major US stock indices rose, with the Dow Jones up by 500 points, breaking through the 37,000-point mark for the first time and setting a new record high.

Gina Bolvin, CEO of Bolvin Wealth Management Group, wrote in a report, "The Fed has given the market an early holiday gift today when, finally, for the first time, they have commented positively about inflation."

When to cut interest rates becomes a new challenge

In general, there are several reasons why the Fed may decide to cut interest rates. One reason is a significant increase in unemployment during an economic recession, and another reason is when inflation has reached the Fed's target of 2%.

If the Fed fails to cut interest rates in these two situations, the economy will face the burden of prevailing interest rates and low inflation.

Regarding the criteria for cutting interest rates, Jerome Powell mentioned that although the Fed hopes to reduce inflation to 2%, waiting until inflation reaches 2% before cutting interest rates would be too late. According to the economic forecast report, the Fed's preferred inflation indicator, the PCE price index (Personal Consumption Expenditures Price Index), will decline from 2.8% in 2023 to 2.4% in 2024.

Vanguard analysts believe that achieving the last mile towards 2% inflation will be the most challenging.

Currently, investors can pay attention to future inflation data trends to identify potential clues about interest rate cuts.