Fed’s Dovish Pivot Reflects Lessons From History

The market anticipates a swift shift in the Fed cycle.

Following its December meeting, Federal Reserve officials underscored a growing confidence in their ability to guide the U.S. economy toward a soft landing, and therefore begin the process of cutting rates. As Fed Chair Jerome Powell himself stated in a 2018 speech, monetary policy strategy is an exercise in risk management. By softening the hiking bias embedded in previous Federal Open Market Committee (FOMC) statements, and lowering the projected path of the federal funds rate, FOMC participants signaled they believe the balance of risks has shifted squarely in favor of achieving sustainably lower inflation. Thus, chances of further rate hikes have diminished, and FOMC discussion is quickly shifting toward the economic conditions that would warrant rate cuts.

Because Chair Powell told reporters afterward that the FOMC had discussed the prospect of rate cuts at this meeting, markets have begun to focus on how soon and how many cuts could come. However, with the economy still proving resilient, Fed officials will likely want to hold off until additional evidence shows inflation is continuing to moderate back to the central bank’s 2% target.

Still, history suggests that once the Fed does begin to cut, the pace could be more rapid than that implied by the FOMC’s projected median interest rate path through 2025. Both forecasters and markets have tended to underestimate the speed and magnitude of the central bank cutting cycle when rates are at their peak.

The December meeting

The central bank held its policy rate steady at 5.25%–5.5%. It also released updated economic projections that we view as consistent with growing confidence that the U.S. economy will achieve a soft landing. These projections include a median outlook for 75 basis points (bps) of net rate cuts in 2024 – up from 50 bps previously projected – consistent with the Fed’s outlook for a slightly faster moderation of inflation to target, with only a modest rise in the unemployment rate.

The committee also softened the rate-hiking bias embedded in its forward guidance by inserting the word “any” into the sentence, “In determining the extent of any additional policy firming that may be appropriate… .” This suggests that while the FOMC doesn’t want to completely rule out additional hikes, officials are now more confident in having reached the terminal level of this hiking cycle.