MNI FED WATCH: Patiently On Hold But Cuts To Come This Year

The Federal Reserve is expected to hold its benchmark overnight rate at a 23-year high for a fifth straight meeting Wednesday, and reaffirm plans to begin lowering borrowing costs later this year if inflation sustains its downward trend.

With PCE inflation having fallen to 2.4% in January from 5.5% a year earlier and the unemployment rate still a robust 3.9%, the U.S. central bank is "not far" from having the confidence to start cutting rates, Fed Chair Jerome Powell told lawmakers this month.

But firmer-than-expected CPI and labor market data to start the year have prompted investors to pare back bets on cuts. Futures traders are now pricing in 75 bps in cuts by year end, matching officials' December median projection, with a greater than 50% chance of the first move in June. (See MNI INTERVIEW: No Fed Cuts Until H2, Hoenig Says)

The debate over when to slow the pace of balance sheet reduction is also set to kick off at the March meeting. Officials have signaled they intend to taper QT before the level of reserves in the banking system declines significantly, and long before reserves fall to an "ample" level that comfortably but efficiently meets banks' demand.

LITTLE CHANGE IN SIGNAL

The vast majority of FOMC members are expected to write down two, three or four cuts this year in their quarterly update to the Summary of Economic Projections.

In December, 15 out of 17 officials were nearly evenly split on those cuts projections, with the median landing on three cuts. It would only take a couple hawkish moves to tip the median to two cuts at this meeting, and sideways-moving inflation data in January and February against a backdrop of resilient growth could persuade some officials to delay cuts.

Stubborn inflation pressures are still plaguing the U.S. economy, even if the recent productivity boom has helped offset the inflationary effects of tight labor markets. Even the possibility of additional rate increases cannot be ruled out, warned Viral Acharya, a former resident scholar at the New York Fed and former deputy governor of the Reserve Bank of India.

As long as growth and and the labor market stay healthy, the FOMC is expected to move slowly in dialing back its restrictive stance even once rate cuts get going. Former St. Louis Fed President James Bullard, who favors lowering the fed funds rate sooner, said Powell needn't promise a sequence of cuts but should stay data dependent.

QT DEBATE BEGINS

Even after rates begin to normalize, Fed officials have signaled they intend to keep QT running but at a slower pace so as to avoid causing unnecessary spikes in money market rates.

That difference in approach from the 2017-2018 will also shape the QT discussions this year. The current pace of runoff is about twice that of the first half of 2019, but so far it's only drained funds from the Fed's overnight reverse repo facility rather than bank reserves, which are above USD3.6 trillion, more than when QT started.

Fed officials need to decide at which point to slow the pace of reduction to give them more time to assess any money market response adjustments on the part of financial institutions. Dallas Fed President Lorie Logan has argued QT should slow when ON RRP balances approach a low level.

No decision on that is expected at this meeting. As for when to stop QT altogether, officials are prepared to wait even longer to see signs of tightening of money market conditions or usage of the Fed's recently created standing repo facility and discount window, hoping that QT can run for as long as the banking system will allow.