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Fed rate cuts? A strong US economy requires a difficult decision – Financial Times

Strong U.S. growth is likely to bolster Federal Reserve officials' belief that they can afford to take their time cutting interest rates as they prepare for their meeting on Wednesday.

The Federal Open Market Committee will almost certainly vote to keep interest rates unchanged at a 23-year high of 5.25 to 5.5 percent after a long attempt to curb rampant inflation.

The question remains, however, to what extent Fed Chairman Jay Powell will hint at imminent interest rate cuts. About half of investors currently expect a move at the Fed's next meeting in March, but many economists are pointing to late spring or early summer instead.

The concern among rate setters is that an early cut could lead to a resurgence in price pressures. Those betting on a later move say the U.S. economy is healthy enough for the Fed to mitigate that risk by keeping interest rates higher for longer.

Gross domestic product grew at an annual rate of 3.3 percent in the fourth quarter, marking a strong end to a year in which many economists had expected the U.S. to slip into recession.

Full-year growth was 3.1 percent – ​​the best performance of any major advanced economy.

“There is simply nothing in the data since the beginning of the year that suggests the economy is in danger,” said Krishna Guha, a former Fed official who now works at Evercore ISI.

“If you're a policymaker, you have a lot of freedom to decide when you go. And a later start meets that desire to confirm that everything is on track to bring inflation back to 2 percent on a sustained basis,” he said.

Last month, Fed Governor Christopher Waller said he was confident the central bank was “within touching distance” of meeting its 2 percent inflation target after price pressures eased sharply in the second half of 2023.

But he argued that strong growth and a tight labor market meant officials didn't need to act too hastily. “I don’t see any reason to move as quickly or cut back as quickly as we have in the past,” Waller said.

Seth Carpenter, an economist at Morgan Stanley who expects the first cut to come in June, said different speculations about the timing of the cuts reflect very different views on the outlook for the U.S. economy.

“Some people still believe there will be a recession in 2024,” Carpenter said. “Others think inflation is now completely under control.”

“We expect a soft landing, but we are not in a completely different place than the markets,” he added. “If we are wrong in June then I would assume it will be because the cuts will come earlier rather than later than our baseline.”

Fed watchers assume that, barring an economic catastrophe, rate setters will want to signal at a meeting in advance that interest rate cuts are imminent.

“I would assume that if they were planning for March, we would get a pretty clear indication of that from Powell in January,” said Guha, who predicted May or June as the most likely time for the first cut.

But some say it would be difficult for Powell to give clear indications of such a move this week as headline U.S. inflation rose to 3.4 percent last month from 3.1 percent in November.

However, the measure the Fed is watching most closely, core PCE inflation, fell to an annual rate of 2.9 percent in December.

The Fed chair may also be reluctant to definitively rule out a rate cut on March 20, as two more data sets on nonfarm payrolls, the key indicator of the health of the U.S. labor market, are scheduled to be released in the meantime.

A January PCE inflation report and two sets of headline inflation numbers are also expected ahead of the March meeting, as well as data revisions showing the extent to which seasonal adjustments influenced the December increase.

“Data flow is going to be very important,” Carpenter said.

Another topic at the Fed meeting is whether quantitative tightening should be slowed. The Federal Reserve is currently wasting up to $60 billion in U.S. Treasury bonds and $35 billion in other government securities each month.

However, minutes from the December meeting noted that some members felt that QT's pace needed to be reviewed soon.

A sharp decline in money market funds' use of a facility to buy and sell government bonds by the central bank could mark the beginning of the end of a period of ample liquidity, they said.

Since then, Lorie Logan, president of the Dallas Fed and former head of the New York Fed's market team, has suggested that a slowdown in the QT pace could reduce the likelihood of a rise in funding costs.

Avoiding those jumps would allow the Fed to continue shrinking its balance sheet uninterruptedly for longer, she said.

Nate Wuerffel, former head of domestic markets at the New York Fed and now at BNY Mellon, said sharp increases in funding costs during previous QT episodes in 2019 would prompt officials to make a decision sooner rather than later.

“There’s this idea of ​​slowing down and then stopping [the run-off of assets] long before reserves go from plentiful to plentiful,” Wuerffel said.

“Policymakers are talking about this because some of them have very deep memories of the 2019 experience and they want to give the banking system time to adjust to lower reserve levels,” he added.

“You know there are limits to what the data can tell us about the behavior of money markets,” Wuerffel said.