Fed Eyes Cautious Rate Cuts Amid Economic Resilience and Inflation Woes

U.S. stock markets opened mixed on Wednesday as investors' attention was squarely focused on the Federal Reserve's meeting, where officials were expected to discuss borrowing costs. While a rate cut seemed likely, it could be smaller than previously anticipated. The Fed also signaled a potential slowdown in rate reductions for the next year, reflecting the stronger-than-expected resilience of the U.S. economy, slower-than-hoped-for declines in inflation, and an unexpectedly robust labor market.

The Fed's shift in economic outlook might lead to an adjustment in the language of its policy statement and an updated trajectory for borrowing costs. Stronger data have sparked debates over whether to raise the neutral rate, possibly justifying the Fed's cautious pace. The Fed's rate decision and the latest quarterly economic forecasts are scheduled for release at 3 a.m. Beijing time Thursday, followed by a news conference by Chairman Jerome Powell.

Tim Duy, Chief U.S. Economist at SGH Macro Advisors, highlighted the uncertainty at play, suggesting it offers more reasons for a gradual approach to rate reduction. "As we near the upper bounds of these estimates, it makes sense for the Fed to adopt a more cautious pace when assessing its position in the policy cycle," he noted.

Most market participants expect the Fed to lower the benchmark interest rate by a quarter percentage point, bringing the federal funds rate target range to between 4.25% and 4.5%. However, this rate is significantly higher than the 2.9% neutral rate projected by officials in September, which indicates that there's been an upward revision in policymakers' estimates of this rate and offers insights into why some support shrinking the magnitude of rate cuts.

Economic forecasts also show that recent data suggests stronger economic performance than anticipated during the last prediction update. Consequently, policymakers may revise the economic outlook, indicating higher inflation, lower unemployment, and more robust growth. The so-called "dot plot" will reflect the projected rate path, expected to show fewer cuts next year compared to the September forecast.

An informal survey among economists shows anticipation for three rate cuts next year, reflecting a reduction from the original forecast. Comments from some Fed officials suggest that the core PCE inflation data in November, while expected to be weak, might influence officials' attitudes, reinforcing decisions to proceed with additional rate cuts.

The upcoming statement is likely to maintain language from November regarding the risks being "roughly balanced" towards achieving employment and inflation goals, while potentially introducing language about "gradually" lowering rates or signaling an impending pause in cuts. Some economists believe that following a cut this week, the Fed might refrain from changing rates in January.

Chairman Jerome Powell's subsequent press conference will likely provide deeper insights into how officials are interpreting economic data and its policy implications. Investors will keenly follow any hints about the future policy trajectory, as well as Powell's comments on the Fed's progress towards inflation goals and the optimistic job market outlook.