The Federal Reserve still expects to slash interest rates multiple times this year even as inflation remains well above its target, sending a welcome message to investors Wednesday.
Fed Chairman Jerome Powell testifies before lawmakers this month.
The Fed’s policy-setting Open Markets Committee opted to hold the target federal funds rate firm at the 5.25% to 5.5% level it’s sat since last summer, according to a release from the central bank following the panel’s Tuesday and Wednesday meetings.
But more pressing from the Fed’s announcement was the revelation that Fed staff’s median year-end forecasts still call for 75 basis points worth of interest rate cuts, a consensus that was put in doubt as early 2024 inflation data came in hotter than expected.
Equities responded positively to the Fed release, with 10-year U.S. Treasury yields dipping about five basis points and the S&P 500 gaining slightly immediately after (lower bond yields means higher value of bonds).
The Fed’s median long-run forecast for interest rates did tick upwards from 2.5% to 2.6% from December to March, perhaps confirming economist warnings that interest rates are likely to remain well above the levels they were for the last decade.
Investors consider the Fed’s June meeting to be the most likely time for the first rate cut since March 2020, according to “Fed swap” futures contracts betting on the direction of the federal funds rate as tracked by CME Group’s FedWatch Tool shortly before Wednesday’s announcement. The market prices in a 55% chance of the first cut coming in June, a 49% of the first one coming in July and just a 7% chance of a May cut. The most likely implied scenario by year’s end is 75 basis points of cuts, a notable decrease from the 150 basis points of cuts indicated as recently as January.
For most of December and January, investors targeted this Fed meeting as the date of the Fed’s first rate cut, effectively concluding the current tightening cycle. At the turn of the year, futures contracts implied a roughly 90% chance the Fed would lower rates by March, according to the FedWatch Tool.
The target federal funds rate only nominally sets the rate at which financial institutions can lend extra cash to one another, but has wide-sweeping implications for the broader economy and financial markets. Higher rates send up borrowing costs, hitting everything from mortgages to government debt, can cripple businesses reliant on low-rate financing (see regional banks and commercial real estate), and can cause stock market losses as investors shun uncertain equity bets for government bonds’ ultra-safe but still high rates of returns.
The muted rate cut expectations came as January and February inflation data revealed price increases have not disappeared, throwing a wrench in the expectations for a softer Fed as the 2022-23 rate increases from near 0% to over 5% began to combat worrisome inflation. Major U.S. stock indexes have proven surprisingly resilient despite the rate hikes, with the S&P 500 bouncing back from its nearly 20% loss in 2022 to set fresh all-time highs this year, though much of the recovery has been concentrated among bigger stocks, as the small-cap Russell 2000 index still sits almost 20% below its 2021 peak.