The Fed pivots

Jerome Powell completed his change of tune at the December FOMC meeting and handed markets an early Christmas present. The committee held the benchmark rate at 5.25–5.50 per cent, but its dot plot now shows three cuts in 2024, with the median year-end projection lowered to 4.6 per cent. Powell said plainly that cuts are coming into the discussion as inflation eases.

From higher for longer

The shift is large for a three-month span. In September the median official expected one more rise this year and a rate of 5.1 per cent at the end of 2024, a message markets summed up as higher for longer. The new projections drop the extra rise, add a further half-point of cuts for next year and pencil in a rate of 3.6 per cent by the end of 2025. Officials also lowered their forecasts for core inflation, which gives the easier path its justification.

The inflation revision was the heart of it. The median official now expects core PCE inflation of 3.2 per cent for this year, down from 3.7 per cent in September, and 2.4 per cent for 2024. The decision to hold was unanimous, the third meeting in a row without a change. A committee that was split between one more rise and a pause in September has converged, within a single quarter, on a pause followed by cuts.

Why cut before the job is done

The logic is about real rates, not surrender. If core inflation falls to 2.4 per cent next year and the policy rate ends it at 4.6 per cent, the inflation-adjusted rate would still be above 2 per cent. The committee's long-run estimate of the neutral policy rate is 2.5 per cent, which with 2 per cent inflation implies a neutral real rate of only half a point. Three cuts on those numbers keep policy tight; holding at today's level would tighten it further every month that inflation slows. That is the case Christopher Waller made in November, and the dots show that most of his colleagues now accept it.

Powell follows the market

The Fed could have leaned against the easing in financial conditions. It endorsed the market's view, signalling that its attention has moved from inflation risk to protecting growth. The response was a rally in nearly everything. Government bond yields fell and stock indices hit records, while credit spreads narrowed to levels rarely seen. In practice the central bank has called time on the tightening cycle.

The Dow Jones Industrial Average closed above 37,000 for the first time on the day of the decision, and the ten-year Treasury yield dropped below 4 per cent the following day. Those moves loosen financial conditions further and amount to easing the Fed has not yet delivered. Mortgage rates, which follow long-term yields, have come down from their autumn peak, and that relief reaches households well before any cut in the policy rate.

The biggest beneficiaries are borrowers who pay floating rates or must refinance soon: small companies, commercial property owners with loans maturing next year and regional banks holding bonds bought when yields were low. Savers in money-market funds lose the least in the short run, since their yields follow the policy rate and that has not moved. The dollar's slide helps American exporters and emerging-market borrowers with dollar debts.

Europe did not follow

The contrast with Europe was sharp. A day after the Fed's decision, both the European Central Bank and the Bank of England held their rates and pushed back against talk of early cuts, even though euro-area inflation has fallen faster than America's. Christine Lagarde said the governing council had not discussed cuts at all. That leaves the Fed as the first big central bank to point openly towards easing, which is one reason the dollar weakened after the meeting.

The ECB went further in the other direction on its balance sheet. It said it would start running down the bonds bought under its pandemic purchase programme during the second half of next year, earlier than it had previously indicated. The Bank of England kept Bank Rate at 5.25 per cent and repeated that policy would need to stay restrictive for an extended period. The Fed's pivot therefore widens the gap between American and European policy expectations, at least for now.

A precedent from 2019

The closest parallel is January 2019. After raising rates in December 2018 into a falling stockmarket, Mr Powell switched within weeks to a promise of patience, and the Fed was cutting by the summer. That pivot also began as a change of language before any change in rates, and markets moved ahead of the committee then too. The difference is that inflation in 2019 was below target, whereas it is still above target now, which gives the Fed less room to be generous.

Where the pivot could stall

The strongest objection is that the Fed has eased financial conditions before finishing the job. On Friday John Williams, president of the New York Fed, said it was premature to be thinking about a cut as early as March. If lower yields and higher share prices revive spending, or if services inflation stays sticky, the committee could hold for longer than the dots suggest. The next tests are the December inflation figures, due in January, and the Fed's meetings at the end of January and in March.

Markets have already gone further than the dots. Futures now imply roughly twice as much easing next year as the committee's median, and a first cut by March. If the committee sticks to its own projections, some of the rally in short-dated bonds will unwind even though the direction of policy has turned.

The tightening campaign is over. Powell has shown he is willing to cut before inflation is fully back at target, and the first move could well come early in 2024. The likelier timing, given Mr Williams's caution and the sticky services data, is the spring or early summer rather than March, and the total for the year is more likely to match the dots than the futures curve.