FOMC Preview: A Data-Dependent and Balanced Approach

Summary:

• The July FOMC meeting is expected to have minimal impact on market repricing. The Federal Reserve is anticipated to hold interest rates steady, with a potential rate cut in September, supported by recent economic data advocating a cautious approach to policy adjustments.

• While the Federal Reserve is not expected to pre-commit to a rate cut in September, it is likely to emphasize its shift in focus from solely targeting inflation to also considering maximum employment.

• Market expectations are projected to continue diverging from June's Dot Plot until the next FOMC meeting. The June dot plot indicated a higher median Fed Funds rate by the end of the year compared to bond futures market pricing. This divergence may persist until September, when the Fed will present a new Dot Plot and updated macroeconomic projections.

Monetary Policy Decision Outlook.

In the upcoming Federal Open Market Committee (FOMC) meeting, the Federal Reserve is expected to hold interest rates steady at 5.25%-5.50%, with bond future markets pricing only a 6% chance of a rate cut at this meeting. However, a rate cut is highly anticipated for the September meeting, with SOFR futures pricing in a full 25 basis points cut and nearly two more cuts by the end of the year.

Contrast with June's Dot Plot.

Bond futures market expectations contrast starkly with what policymakers signaled in June’s dot plot, which indicated a median rate of 5.1%, suggesting fewer than two full rate cuts by the end of the year. Additionally, the long-term neutral rate in the dot plot has been rising, moving from 2.5%, where it stayed since June 2019 until March this year, to 2.75% currently. This increase in the long-term neutral rate suggests that the Federal Reserve is not looking to engage in an aggressive interest rate-cutting cycle as previously expected.

Economic Data and Market Expectations.

Current market expectations of upcoming rate cuts are based on concerns that inflation is on a downward trajectory to 2% the U.S. economy is slowing.

Headline CPI rose 3% YoY in June, marking its slowest annual increase in a year. On a MoM basis, inflation fell 0.1% for the first time since May 2020. Core CPI increased by just 3.3% YoY, the slowest rise since April 2021, and ‘supercore’ inflation saw its second straight monthly decline, to 4.7% YoY. Friday’s PCE numbers also showed that price pressures were coming off, and could likely give the FOMC greater confidence that inflation is moving closer to the Fed's 2% target.

Consumers are pulling back on spending, which accounts for roughly 70% of the country's economic activity. Meanwhile, the labor market is loosening, with unemployment rising from 3.8% in March to 4.1% in June, the first increase since November 2021.

However, despite GDP growth falling from 4.9% in the third quarter of 2023 to 1.4% in the first quarter of this year, preliminary GDP data for the second quarter showed the U.S. economy growing at 2.8%, exceeding expectations as domestic demand remained strong. This growth data rules out a rate cut this week and casts doubt on the aggressive rate-cutting cycle anticipated in bond futures markets.

September Rate Cut Consideration.

The question is whether policymakers feel confident enough to pre-commit to a rate cut in September. Although the exact timing and magnitude of rate cuts will depend on forthcoming economic data, it’s likely the Fed will convey its intention to balance its dual mandate while avoiding premature policy shifts. This will solidify market expectations of rate cuts beginning in September, followed by regular cuts throughout the rest of the year, as the central bank shifts its focus from solely inflation to also considering maximum employment.