INSIGHTS &PERSPECTIVESAPRIL 2023

Is the Fed on the Verge of Cutting Rates?
Authored by Steven Friedman, Managing Director andSenior Macroeconomist

Don’t count on it. The Fed is willing totolerate labor market pain in order to bringinflation back to target and make sure it
stays there.
The data flow this week has been fairly weak, and coming on
the heels of concerns about a coming credit crunch, it has led
to increasing expectations for Fed rate cuts in the near term.
In fact, markets are now pricing less than 50 percent odds ofFIGURE 1: FED FUNDS RATE AND MARKET-DISCOUNTED RATEAFTER FOMC MEETINGS IN THE SECOND HALF OF THE YEAR
6.0

5.0
Percent

JulSepNov
Dec

4.0
POLICY RATE

3.0
Nov-22

Dec-22

Jan-23

Feb-23Apr-23

Data as of April 6, 2023
Market-discounted rate refers to the expected policy rate following FOMC
meetings based on the prices of overnight index swaps.
Source: Bloomberg

a final rate hike in June, and an 80 percent probability of a rate
cut at the July meeting. This is occurring despite the Fed
signaling one more rate hike, and no cuts until next year.
Investors appear to view recent data, especially the February
Job Openings and Labor Turnover Survey and the March ADP
employment report, as fitting into a narrative of immediate andrapid disinflation, or a Fed that will get “cold feet” if the labormarket shows signs of softening over the next few months.
Last fall, in response to questions from clients and colleagues,
I had put together a “Fed pivot checklist” when market chatterfirst emerged about the Fed not following through on
telegraphed rate hikes, or cutting rates quickly after theterminal rate had been reached. I retired the checklist early
this year as discussion shifted to the potential for additional
rate hikes. But given that markets are again pricing inmeaningful rate cuts, I've dusted it off. It remains a useful
guide for considering what it would take for monetary policy todiffer significantly from what FOMC members arecommunicating. The checklist suggests that there is still a highbar for rate cuts.
First, policy-makers would need clear and convincing evidence
that inflation is on a path back to two percent on a sustainablebasis. In my view, that requires at least three months of core
Personal Consumption Expenditures (PCE) inflation 1 running ator below a 2.5 percent annualized rate. And the underlying
disinflation has to be evident not just in goods, but services aswell.
Second, wage gains would need to moderate to a level that isconsistent with inflation moving back to target. In theory, thatlevel should be the inflation objective of two percent, plus anestimate of productivity growth. In my prior note I had said that
this equates to a wage gains pivot threshold of 3.25 percent.
But Powell has specified 3.5 percent, based on a rosier

1. PCE inflation: change in the Bureau of Economic Analysis’ price index for personal consumption expenditures

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recent banking sector turmoil may serve as a meaningful
headwind to credit growth. But policy-makers have set a highbar for rate cuts. Absent a very sharp slowdown in the labormarket and a rapid disinflation in prices and wages, market
expectations for near-term rate cuts are very likely to bedisappointed.

productivity growth estimate, so I will use that as my pivot
threshold.
Third, an unemployment rate at or above the median FOMC
participant’s estimate of its longer-run equilibrium level of fourpercent. As long as the unemployment rate remains below thislevel, the Committee will not be convinced that inflation will
return to the two percent objective and stay there.

FIGURE 2: FED PIVOT CHECKLIST
Condition

And fourth and fifth, well-anchored short- and long-term
inflation expectations.
Of these conditions for policy to deviate meaningfully fromwhat is being communicated, only the last two - well-anchoredinflation expectations at all horizons – are currently being met.
Core inflation is running at an annualized rate of 4.9 percent
over the past three months. My preferred wage measure, theAtlanta Fed’s wage tracker 2, is still running at a 6.1 percent
y.o.y. rate. And while the unemployment rate rose slightly in
February from a 53-year low, at 3.6 percent it is still far too low
for the Fed to believe that any sustained disinflation will prove
durable.
A lot can change over the next few months. The effects of past
tightening now seem to be taking hold more broadly, andCondition Met?

CORE PCE INFLATION RUNNING AT AN
ANNUALIZED RATE OF 2.5 PERCENT OR
LOWER, FOR AT LEAST THREE MONTHS.
DISINFLATION MUST BE EVIDENT IN CORESERVICES

No

WAGE GAINS CONSISTENT WITH PRICESTABILITY (3.5% OR LOWER)NoUNEMPLOYMENT RATE OF 4% OR HIGHER

No

WELL-ANCHORED LONG-RUN INFLATIONEXPECTATIONS

Yes

WELL-ANCHORED SHORT-RUN INFLATIONEXPECTATIONS

Yes

Source: MacKay Shields

2. Atlanta Fed Wage Growth tracker: The Atlanta Fed’s Wage Growth Tracker provides an estimate of nominal wage growth based on survey data. Moreinformation can be found here: https://www.atlantafed.org/chcs/wage-growth-tracker.

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