Fed's Rate Cut Path to Proceed Gradually

 

On November 26th local time, the Federal Reserve released the minutes of the Federal Open Market Committee (FOMC) meeting held on November 6th and 7th. The minutes revealed that all participants agreed to lower the target range for the federal funds rate by 25 basis points and believed that if inflation steadily declines to 2% and the economy continues to approach the maximum employment target, gradually shifting to a more neutral policy stance would be appropriate. However, some officials warned that if the progress of inflation improvement stalls, the pace of rate cuts may slow down or even pause.

The minutes reflected the cautious attitude of Federal Reserve officials towards the policy path. Ian Lyngen, a rate strategist at BMO Capital Markets, told Yicai Global: "In short, the Fed acknowledges the market's concern that the process towards a neutral interest rate may be underway, but this target is still unclear. We believe that the neutral interest rate is likely to be a dynamic target, which will make the process of readjusting policy rates more complex."

The path of rate cuts becomes more cautious.

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The minutes showed that Federal Reserve staff raised their inflation forecast for 2024, expecting the overall personal consumption expenditure price index (PCE) inflation and core PCE inflation to fall to the 2% target level by 2026. Staff believe that the recent robust performance of the labor market provides support for achieving this inflation expectation.

The labor market remains robust, and participants believe that the current employment situation provides strong support for inflation control. Despite strikes and hurricanes causing short-term disturbances to October's employment data, layoffs remain at a low level, and the overall trend is in line with the full employment target. Some officials mentioned that factors such as immigration, natural disasters, and data revisions make the assessment of long-term trends challenging, but overall, the health of the labor market provides support for further adjustments in monetary policy.

Officials mentioned that the recent performance of the financial market is supported by the improvement of inflation expectations. Despite the rise in U.S. Treasury yields, corporate earnings exceeded market expectations, and coupled with increased confidence in economic growth, the stock market has risen significantly. At the same time, household balance sheets remain robust, with high net worth levels and low mortgage delinquency rates, providing additional support for the economy.

Regarding future interest rate policy, officials emphasized that if the economy performs as expected and inflation continues to decline, gradually approaching a neutral interest rate would be appropriate. At the meeting, all 19 participants unanimously agreed to lower the benchmark interest rate by 25 basis points. However, some officials said that the current level of interest rates still needs to be carefully assessed for their tightening effect on the economy, and there is still considerable uncertainty about the future path of rate cuts.

According to CME Watch data, traders expect a 59.6% chance of a 25 basis point rate cut by the Federal Reserve in December, higher than the previous 52.3%. Forexlive analyst Adam Button said that the minutes sent a signal of gradually adjusting policy, with only "a few" officials discussing the possibility of pausing rate cuts.

Adjustment of the overnight reverse repurchase tool rate.

The minutes also discussed technical adjustments to the overnight reverse repurchase tool (ON RRP), with staff suggesting a 5 basis point rate cut to align it with the lower bound of the federal funds rate target range. Officials believe that this adjustment may put some downward pressure on short-term money market interest rates while optimizing liquidity management.

Staff reviewed the usage trends of the overnight reverse repurchase tool, believing that it has become an important means of regulating liquidity and stabilizing the money market. However, the resumption of the federal debt limit in 2025 may pose a challenge to the assessment of money market reserves and obscure the effects of balance sheet reduction. Against this backdrop, the proposal to adjust the ON RRP rate is seen as a technical optimization rather than a significant change in policy direction.

Since reaching its peak in December 2022, the balance of the overnight reverse repurchase tool has decreased by about $2.4 trillion, but the rate of decline has slowed in recent months. The overnight reverse repurchase balance is widely regarded as a key indicator of excess market liquidity, reflecting the impact of the Federal Reserve's balance sheet reduction on liquidity.

Goldberg, head of U.S. interest rate strategy at TD Securities, said that the Federal Reserve's mention of adjusting the overnight reverse repurchase rate in the minutes means that if money market interest rates are under pressure at the end of the month or year, the Federal Reserve may take action. However, he also believes that given the recent continuous decline in overnight reverse repurchase balances, this adjustment may not happen soon. Data shows that as of November 26, the overnight reverse repurchase balance fell to $148.8 billion, the lowest level this month.