At its meeting on October 28-29, the Fed cut interest rates by 25 basis points for the second time this year, to 3.75-4.0%. The decision was in line with market expectations. A notable feature of the meeting was that, due to the US government shutdown that began on October 1, many regular official statistics were unavailable to the members of the Open Market Committee, including the BLS report on the labor market for September.
It has become quite rare for two FOMC members to vote against a majority decision with opposing arguments—Fed Governing Council member and recent Trump appointee Stephen Muran, once again advocated a 50 basis point rate cut, while Kansas City Federal Reserve Bank President Jeffrey Schmid argued for keeping rates unchanged. The Fed also announced that it would end its balance sheet reduction (QT) program on December 1. Currently, the Fed allows redemptions without reinvestment for government bonds on its balance sheet in the amount of up to $5 billion per month, and for mortgage-backed securities (MBS) in the amount of up to $35 billion per month. Starting December 1, the Fed will extend Treasury bonds with approaching maturity dates. As for mortgage-backed securities, the Fed will continue to allow monthly redemptions of up to $35 billion per month, but starting December 1, all proceeds from MBS redemptions will be reinvested in Treasury bills. Thus, by keeping its balance sheet stable from December 1, the Fed will effectively increase its investments in Treasury securities.
The Fed's statement asserts that available indicators point to moderate growth in economic activity. Employment growth slowed this year, and the unemployment rate increased slightly but remained low through August; more recent indicators are consistent with this pattern. Inflation has risen since the beginning of the year and remains somewhat elevated relative to the Fed's long-term goal. An important conclusion is that the risks of a decline in employment have increased in recent months. As is well known, the Fed's dual mandate is to ensure price stability (an inflation target of 2%) and maximum employment.
The main point of Powell's press conference was his statement that during the discussions, there were serious disagreements among the Committee members regarding further actions in December. According to him, a further reduction in the key rate at the December meeting is not a foregone conclusion: “We continue to analyze the incoming data, the evolving outlook, and the balance of risks.” He also added the traditional phrase that the Fed's policy does not follow a predetermined course. Furthermore, in response to a question, he explained that the central bank may act more cautiously at its December meeting. Firstly, due to insufficient economic data during the shutdown, and secondly, because the steps to reduce the rate by a total of 50 basis points in September and October were taken for risk management purposes, with the aim of approaching a neutral monetary policy level, but further steps “are another matter.” Recall that following the September meeting, the median forecast of committee members assumed two more rate cuts of 25 basis points each in October and December.
Key points from Powell's speech:
Economy: Although the release of some important federal government data has been delayed due to the shutdown, available data from government and private sources indicate that the outlook for employment and inflation has not changed significantly since the September meeting. Labor market conditions are gradually cooling, while inflation remains somewhat elevated. Available indicators point to moderate growth in economic activity. GDP grew by 1.6% in the first half of the year, compared with 2.4% last year. Data available before the government shutdown suggest that economic activity may be on a somewhat more sustained path than expected, primarily due to growth in consumer spending. Business investment in equipment and intangible assets continues to grow, while activity in the housing sector remains weak. The federal government shutdown will put pressure on economic activity, but this impact should reverse once the shutdown ends. An interesting conclusion about the “bifurcation” of consumer behavior "On the K-shaped economy … if you listen to the earnings calls or the reports of big public consumer-facing companies, many, many of them are saying there is a bifurcated economy there and that consumers at the lower end are struggling and buying less and shifting to lower-cost products. But at the top, people are spending, at the higher income and wealth.."
Labor market: Job growth has slowed significantly since the beginning of the year. Much of this slowdown likely reflects slower labor force growth due to immigration restrictions and lower labor supply, although labor demand has also clearly declined. Available data suggest that both layoffs and hiring remain low, and that both households' perceptions of job availability and firms' perceptions of hiring difficulties continue to decline. In this less dynamic and somewhat calmer labor market, the risks to employment appear to have increased in recent months. However, Powell does not yet see any sign that the weakness in the labor market has intensified or that anything more than a gradual cooling is taking place—in particular, there has been no significant increase in unemployment claims. “We see a significant number of companies either announcing hiring cuts or actually laying off employees, and most of the time they talk about AI and its capabilities... we are watching this very closely.”
Inflation: According to J. Powell's estimates, the overall inflation rate (PCE) targeted by the Fed in September was 2.8% y/y, and the core inflation rate, excluding volatile food and energy categories (Core PCE), was also 2.8% y/y. These figures have risen since the beginning of the year due to accelerating price growth in goods, while services continue to experience disinflation. Higher tariffs lead to price increases for certain categories of goods, which results in higher overall inflation. The part of service price inflation that is not falling as much as the Fed would like is attributable to the non-market component of inflation, which is not related to the housing sector, but here too, the regulator is hoping for success thanks to still moderately restrictive monetary policy and a cooling labor market. The Fed chairman assessed the September CPI report as somewhat milder than expected. “Inflation, excluding tariffs, is actually not that far from our 2% target.” Powell said that, according to the Central Bank's estimates, the impact of tariffs is approximately five or six tenths of a percentage point in the Core PCE price index, the main inflation indicator targeted by the Fed, i.e., excluding tariffs, core inflation may be in the range of 2.3% to 2.4%. Powell considers it a reasonable baseline scenario that inflation may rise further as a result of higher tariffs, but that this impact will be relatively short-lived — a one-off change in price levels. However, it is also possible that the inflationary effects may be more persistent, and this risk needs to be assessed and monitored. “I think it would be unwise to simply ignore or dismiss the issue of inflation. At the same time, I believe that the risk of higher and more persistent inflation has declined significantly since April.”
Risk balance. In the near term, risks to inflation are skewed to the upside, while risks to employment are skewed to the downside, presenting a challenging situation for the central bank. There is no risk-free path for monetary policy, as we have to navigate this trade-off between our employment and inflation goals. Our approach requires us to take a balanced approach to advancing both sides of our dual mandate. With the risks to employment increasing in recent months, the balance of risks has shifted. Accordingly, we judged it appropriate at this meeting to take another step toward a more neutral monetary policy (now, according to Powell, the Fed's monetary policy is “moderately restrictive”). Powell explained that if the risk of high inflation prevailed earlier, and now the risks of both goals (inflation and employment) are roughly equal, then it is reasonable to move towards a more neutral monetary policy, and the decisions to lower interest rates in September and October were made within the framework of this risk management concept. But further movement is another matter. “If the level of uncertainty (at the December meeting) is very high, then that could be an argument for caution with movement.”
Divided opinions in the committee. Today, completely different opinions were expressed... “We are now at a stage where we have essentially cut rates twice more... we are 150 basis points closer to neutral than we were a year ago.” “There are increasingly voices saying that we should wait and see whether there really are downside risks to the labor market, or whether the stronger growth we are seeing is real.” “I think there are people on the Committee who assess the neutral rate higher, and these positions are debatable because it is impossible to observe it directly.” “People have different forecasts and expectations for the economy, as well as different risk tolerances.”
The impact of the shutdown on the Fed's ability to make decisions. We receive data on inflation and economic activity. We get an idea of what is happening. We will also have the Beige Book. “I would say that we will not be able to get a complete picture of what is happening. But I think that if there were any significant changes in the economy, we would catch them with this analysis.” “If you asked me whether this could affect... the December meeting, I'm not saying it will, but yes, you can imagine it could. You know what you do when you're driving in fog? You slow down.”
The Fed's balance sheet and QT. Over the 3.5 years during which we reduced our balance sheet, our securities holdings declined by $2.2 trillion (from nearly $9 trillion to $6.6 trillion; prior to the COVID-19 pandemic, the Fed's balance sheet was just over $4 trillion). Relative to nominal GDP, our balance sheet has fallen from 35% to about 21%. Our plan was to stop reducing the balance sheet when reserves were slightly above what we thought was sufficient. There are clear signs that we have reached that level. Money market repo rates rose relative to our target rates, and we saw more noticeable pressure on certain dates, as well as more active use of our standing repo facilities. In addition, the effective federal funds rate has begun to rise relative to the interest rate on reserves. This is what we expected given the reduction in our balance sheet, and it justifies today's decision to end the outflow of funds.
We continue to move toward a portfolio consisting primarily of Treasury securities. This reinvestment strategy will also help bring the weighted average maturity of our portfolio closer to the weighted average maturity of outstanding Treasury securities.
The market initially reacted positively to the Fed's expected decision to cut rates by 0.25 percentage points and to the announcement that it would stop reducing its balance sheet from December 1, but then Powell's statement about the “uncertainty” of further interest rate cuts in December caused disappointment. Although, in principle, there is nothing fundamentally new here—the Fed constantly says that decisions are made from meeting to meeting depending on data, forecasts, and the balance of risks, and that monetary policy does not follow a predetermined course. However, there appears to be a greater than usual divide among Committee members in their assessment of the situation and future actions, and decision-making is being hampered by the lack of regular economic data due to the shutdown. Following Powell's statements, the futures market reassessed the probability of a rate cut at the December 9-10 meeting to 70% from approximately 90% prior to the meeting. For the markets, this means support for the dollar against the cost of risky assets, but the December meeting is still a long way off and sentiment may change more than once.
