The Fed has a big interest rate decision on Wednesday. This is what you can expect

Inflation is stubbornly above target, the economy is growing at a rate close to 3% and the labor market remains strong. Add it all up and it seems like a perfect recipe for the Federal Reserve to raise interest rates or at least hold them steady.

However, that’s not what’s likely to happen when the Federal Open Market Committee, the central bank’s rate-setter, announces its policy decision on Wednesday.

Instead, futures market traders are pricing in a near certainty that the FOMC will actually reduce its benchmark overnight borrowing rate by a quarter percentage point, or 25 basis points. That would reduce it to a target range of between 4.25% and 4.5%.

Even with the high level of market anticipation, it could be a decision that is subject to an unusual level of scrutiny. A CNBC poll found that while 93% of respondents said they expected a cut, only 63% said it was the right thing to do.

“I would be inclined to say ‘no cuts,'” former Kansas City Federal Reserve President Esther George said Tuesday during an interview on CNBC’s “Squawk Box.” “Let’s wait and see how the data comes in. Twenty-five basis points generally don’t determine where we are, but I think it’s time to signal to the markets and the public that they haven’t taken their eye off the inflation ball.”

In fact, inflation remains a vexing problem for authorities.

While the annual rate has declined substantially from its 40-year high in mid-2022, it has been stuck in the 2.5% to 3% range for much of 2024. The Federal Reserve is targeting inflation of 2.5% to 3%. %.

The Commerce Department is expected to report Friday that the personal consumption expenditures price index, the Federal Reserve’s preferred inflation gauge, rose in November to 2.5%, or 2.9% in the base reading that excludes food and energy.

Justifying a rate cut in that environment will require some skillful communication from Chairman Jerome Powell and the committee. Former Boston Fed President Eric Rosengren also recently told CNBC that he would not make cuts at this meeting.

“They are very clear about what their target is and as we look at the inflation data, we see that it is not continuing to slow down in the same way as before,” George said. “I think that’s a reason to be cautious and really think about how much of this policy easing is required to keep the economy on track.”

Federal Reserve officials who have spoken in favor of cuts say policy does not need to be so restrictive in the current environment and they do not want to risk damaging the labor market.

If the Fed goes ahead with the cut, it will remove a full percentage point from the federal funds rate from September.

While this is a considerable easing in a short period of time, Federal Reserve officials have tools at their disposal to let markets know that future cuts will not come so easily.

One such tool is the dot matrix of individual members’ expectations about rates over the next few years. This will be updated on Wednesday along with the rest of the Summary of Economic Projections which will include informal outlooks for inflation, unemployment and gross domestic product.

Another tool is to use guidance in the post-meeting statement to indicate where the committee sees the policy going. Finally, Powell may use his press conference to provide more clues.

What markets will watch most closely will be Powell’s speech to the media, followed by the dot plot. Powell recently said the Federal Reserve “can afford to be a little more cautious” about how quickly it eases amid what he characterized as a “strong” economy.

“We will see them lean in the direction of travel, to begin the process of raising their inflation forecasts,” said Vincent Reinhart, chief economist at BNY and former director of the Federal Reserve’s Monetary Affairs Division, where he worked for 24 years. . “The points [will] Go up a little and [there will be] Great concern at the press conference about the idea of ​​missing meetings. “So it will turn out to be a hardline cut in that sense.”

Powell will almost certainly be asked how he would position fiscal policy under President-elect Donald Trump.

The president and his colleagues have so far brushed aside questions about the effect Trump’s initiatives could have on monetary policy, citing uncertainty about what are just words now and what will become reality later. Some economists believe the incoming president’s plans for aggressive tariffs, tax cuts and mass deportations could further exacerbate inflation.

“Obviously the Federal Reserve is in a bind,” Reinhart said. “We used to call it the trapeze artist problem. If you’re a trapeze artist, you don’t leave your platform to swing until you’re sure your partner is swinging out. For the central bank, they can’t really change their forecast in response to what they think will happen in the political economy until they are fairly certain that there will be those changes in the political economy.”

“A big concern at the press conference is the idea of ​​missing meetings,” he added. “So I think it will turn out to be a hardline easing in that sense. [Trump’s] “If policies are actually implemented, they may change the forecast even further.”

Most Wall Street forecasters see Fed officials raising their inflation expectations and lowering expectations for rate cuts in 2025.

When the dot chart was last updated in September, officials indicated the equivalent of four quarter-point cuts next year. Markets have already lowered their own expectations for easing, with an expected trajectory of two cuts in 2025 following this week’s move, according to CME Group’s FedWatch measure.

The prospect is also for the Federal Reserve to skip the January meeting. Wall Street expects little to no change in the post-meeting statement.

Officials are also likely to raise their estimate of the “neutral” interest rate that neither boosts nor restrains growth. That level had been around 2.5% for years (an inflation rate of 2% plus 0.5% at the “natural” interest level), but has slowly risen in recent months and could exceed the 3% in this week’s update.

Finally, the committee can adjust the interest it pays on its overnight repurchase transactions by 0.05 percentage point in response to the federal funds rate drifting to near the bottom of its target range. The “ON RPP” rate acts as a floor for the funds rate and is currently at 4.55%, while the effective funds rate is 4.58%. Minutes from the November FOMC meeting indicated that officials were considering a “technical adjustment” to the rate.