The U.S. financial system’s ‘vulnerabilities’ were ’notable,' Fed policymakers said.

Federal Reserve officials say it isn’t appropriate to reduce interest rates until there is greater confidence inflation is heading toward the central bank’s target, as some policymakers warn that progress on inflation could stall.

According to minutes from the January Federal Open Market Committee (FOMC) policy meeting, officials want to wait for more numbers before cutting the benchmark Fed funds rate. However, they dismissed the possibility of raising rates, noting that the policy rate has likely peaked in the current cycle.

Meeting participants conceded that there is uncertainty surrounding the length of time the policy will remain in the restrictive territory. Officials have said the timing of rate cuts depends on inflation, which could take longer to defeat than originally expected.

“Risks around the inflation forecast were seen as tilted slightly to the upside; although inflation had come in close to expectations throughout most of 2023, the staff placed some weight on the possibility that further progress in reducing inflation could take longer than expected,” the meeting documents stated.

On the broader economy, staff economists stated that the outlook was stronger than December forecasts. At the same time, Fed staff members asserted that there are risks to the economic forecast and that the financial system’s “vulnerabilities” were “notable.”

Last month, the Federal Reserve left interest rates unchanged within a range of 5.25–5.5 percent.

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Federal Reserve Leaves Interest Rates Unchanged, Signals Not Ready to Cut

In recent weeks, the financial markets have been pushing back their rate-cut expectations. Heading into 2024, investors signaled that they were certain the central bank would pull the trigger on a quarter-point rate cut in March.

However, a blend of comments from Fed policymakers and economic data dashed traders’ pivot hopes.

“Traders will be quite cognizant of any key language or dissension of Fed presidents,” Jay Woods, chief global strategist at Freedom Capital Markets, wrote in a note. “It could be telling when it comes to thoughts of a continued pause vs a cut or maybe even, dare I say, another hike at future meetings.”

According to the CME FedWatch Tool, the futures market anticipates that the first quarter-point pivot will not occur until the policy-making FOMC meeting in June.

The annual inflation rate came in at a hotter-than-expected 3.1 percent in January. The core Consumer Price Index, which omits the volatile food and energy prices, was a flat 3.9 percent, higher than the consensus estimate of 3.7 percent.

Producer prices also edged higher than market forecasts. The Producer Price Index (PPI) and the core PPI rose by 0.3 percent and 0.5 percent month over month, respectively.

Balance Sheet Blues

Policymakers have begun discussing the future of the balance sheet tapering.

Rate-setting committee members have said that the Fed’s balance sheet continues to “normalize.” According to the Fed minutes, several officials purported that the balance sheet runoff “could continue for some time” after the central bank started cutting interest rates.

Since the Fed began its quantitative tightening campaign in March 2022, its balance sheet has declined by about $1.4 trillion.

The runoff efforts have stalled in recent weeks, with the balance sheet rising since the end of January by more than $3 billion.

Regional central bank heads, including Dallas Fed President Lori Logan, have suggested that slowing down the pace of reducing its holdings could allow the Fed to extend the FOMC’s tapering.

Despite the decrease over the past couple of years, the balance sheet remains 83 percent above the pre-pandemic level.

High or Low?

During her prepared remarks in front of the National Association for Business Economics (NABE) conference on Feb. 16, Mary Daly, president of the Federal Reserve Bank of San Francisco, recommended the central bank be patient before cutting interest rates.

“We will need to resist the temptation to act quickly when patience is needed and be prepared to respond agilely as the economy evolves,” Ms. Daly said.

Although she said she doesn’t believe in the latest narrative that the last mile of inflation will be harder, Ms. Daly said that “progress is not victory” and the FOMC will “need to deliver more than a few fleeting moments of relief.”

Atlanta Fed President Raphael Bostic suggested financial markets wait until possibly July for the first rate cut.

Mr. Bostic stated in prepared remarks that he continues to be “vigilant” about the risk of cutting rates too soon out of fear of reaccelerating inflation.

“The stronger the economy is, the harder it’s going for prices to fall rapidly,” he said to the Money Marketeers of New York University on Feb. 15. “I do think that in the set of problems to have, this is one of the better ones.”

In the fourth quarter, the U.S. economy expanded by 3.3 percent. Early estimates suggest the GDP will grow by about 2 percent in the first three months of 2024.

One former Fed official presented the case for lowering rates soon.

In a Feb. 17 speech to the NABE’s policy conference, former St. Louis Fed President James Bullard argued that the central bank needs to cut rates rather than wait until the annual inflation rate is at the Fed’s target rate of 2 percent.

“That would be the ‘Honey, I forgot to shrink the policy rate,'” Mr. Bullard said, adding that the economy will be in a ”steady state” of 2 percent economic growth and 2 percent inflation.

In a column for Bloomberg on Feb. 20, former New York Fed Chief William Dudley wrote that the central bank needs to strike the right balance while accomplishing the soft-landing objective.

“It’s possible that developments could push them to keep rates high well beyond May,” Mr. Dudley wrote. “They must also consider the market’s expectations: If hopes for rate cuts are dashed, financial conditions could tighten and restrain growth too much.”

The Chicago Fed’s National Financial Conditions Index shows that there has been some modest tightening in recent weeks, although they remain looser than the average.

Meanwhile, the rate-setting FOMC will still have plenty of data to sift through until next month’s meeting. This includes another jobs report, a few more inflation gauges, and consumer inflation expectations for the year ahead.

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