Federal Reserve sparks market rally as it signals interest rate cuts in 2024

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Federal Reserve chair Jay Powell sent his clearest signal yet on Wednesday that the US central bank was done with two years of tightening monetary policy and would begin cutting rates in 2024, sending Wall Street to new records as investors celebrated the prospects of lower borrowing costs.

The Fed held interest rates at a 22-year high, but the decision came alongside new forecasts from central bank officials pointing to 75 basis points worth of cuts next year — a more dovish outlook for rates than in previous projections.

Powell’s comments after the Fed’s decision also pointed to a switch in tone from the bank. The benchmark rate was now “likely at or near its peak for this tightening cycle”, he said.

The signal of some interest rate relief next year came even as the Federal Open Market Committee unanimously agreed to hold rates at their current 22-year high, at 5.25 per cent to 5.5 per cent.

However, the decision came alongside publication of the Fed’s so-called dot plot, which showed that most officials expected rates would end next year at 4.5 per cent to 4.75 per cent — equivalent to three quarter-point cuts from current levels.

Officials expect rates to fall even lower in 2025, with most officials forecasting they would end up between 3.5 per cent and 3.75 per cent.

Expectations for a steeper pace of rate cuts triggered a rally in US stocks and a sharp fall in Treasury yields, with the two-year yield recording its biggest daily decline since the collapse of Silicon Valley Bank in March.

The two-year Treasury yield, which moves with interest rate expectations, fell 0.3 percentage points to 4.43 per cent after the Fed’s announcement. The benchmark 10-year Treasury yield fell 0.18 percentage points to 4.03 per cent, its lowest level since August.

The benchmark S&P 500 gained 1.4 per cent to close at its highest level since January 2022.

“They went from higher for longer in September to talking about rate cuts,” said Priya Misra, a portfolio manager at JPMorgan Asset Management. “They were behind the curve on inflation, but maybe they want to be ahead of the curve in terms of a slowdown.”

In a statement, the Fed spelt out the conditions under which it would consider “any additional policy firming that may be appropriate to return inflation to 2 per cent over time” — softer language that suggests the central bank may not see a further need to raise rates again.

Powell reiterated that the central bank was committed to proceeding “carefully” with future rate decisions given expectations that economic growth would cool and there had been “real progress” on beating back inflation.

He drove home that point, saying the Fed did not want to restrict the economy longer than necessary.

“We’re aware of the risk that we would hang on too long,” Powell said, referring to waiting too long to cut rates. “We know that’s a risk and we’re very focused on not making that mistake.”

He later added the Fed would not wait until inflation had returned to 2 per cent to begin to cut rates because “you’d want to be reducing restriction on the economy well before” that point “so you don’t overshoot”.

The latest decision comes as the Fed tries to keep monetary policy tight enough to drive inflation back down to its 2 per cent target without damaging the economy and causing too many job losses.

Some traders in futures markets had expected the Fed to begin lowering borrowing costs as early as March, although this week’s inflation data and a solid jobs report on Friday prompted more bets that cuts will begin in May. Leading up to Wednesday’s rate announcement, traders had wagered interest rates could fall more than a percentage point next year.

Projections from Fed officials for unemployment were barely changed from September, with officials still expecting only a slight uptick in the jobless rate to 4.1 per cent in 2024, from 3.7 per cent now.

However, estimates for core inflation, as measured by the personal consumption expenditures index, were lowered slightly, with officials expecting it to hit 2.4 per cent in 2024 and 2.2 per cent in 2025. In September, median projections showed inflation hitting 2.6 per cent in 2024 and 2.3 per cent the following year.

To consider rate reductions, the Fed needs to be confident that inflation is trending back to 2 per cent in a sustainable way. If slower consumer price growth is accompanied by a sharp rise in unemployment, the rationale to cut would be clear.

The looming question is what happens if the economy holds up as inflation falls. Some officials such as John Williams, president of the New York Fed, and Christopher Waller, Fed governor, have suggested that loosening monetary policy could still be necessary so that interest rates, once adjusted for inflation, do not become too restrictive for households and businesses.

Additional reporting by Kate Duguid in New York