Will Fed surprise markets this week?

The US financial markets faced pressure earlier this year amid fears of continued Federal Reserve monetary tightening, fueled by growing concerns about inflation during the first quarter.

However, as price pressures eased and manufacturing and jobs data weakened, recession fears mounted. The Fed concluded its tightening cycle in September after cutting interest rates by 50 basis points (bps).

As the Federal Open Market Committee's (FOMC) final meeting of the year approaches, markets 99% believe policymakers will cut interest rates for the third consecutive time. But what if the central bank surprises markets regarding borrowing costs?

US monetary policy: From tightening to easing

From March 2022 to July 2023, the Federal Reserve raised interest rates 11 times, pushing them close to 0%. The rates remained between 5.25% and 5.50% from July 2023 to September 2024.

The September Fed meeting's minutes showed that one member favored a 25 bps cut to the target borrowing range, marking the first division of opinion since 2005.

In November, policymakers lowered interest rates by 25 bps, and investors are awaiting a third cut in Wednesday's meeting.

Could the Fed surprise the markets?

Comments from the FOMC members since November suggest a reduced urgency to ease policy, as downside risks to economic activity and employment have faded amid slowing inflation.

While Fed policymakers remain confident that inflation is on track to reach the 2% target sustainably, senior FOMC members see a potential "pause" in policy adjustments.

Since the September meeting, futures markets have predicted a 100 bps rate cut by the end of 2025, bringing rates to 3.85%—50 bps higher than the Fed's forecasts. This compares to earlier expectations of 2.85%, 50 bps lower than the Fed’s outlook.

The US economy added 227,000 jobs in November, surpassing expectations of 214,000, while average hourly earnings rose by 0.4%, bringing the annual rate to 4%, also above forecasts.

Following the November jobs report and recent data, several economists and market participants are questioning whether the US central bank should hold rates steady in December.

Economist Bernard Baumohl questioned the Fed's next move, stating the Consumer Price Index rose at its fastest pace in seven months in November. On an annual basis, inflation increased for two consecutive months, moving further away from the 2% target. Yet, there is widespread agreement that the Fed will cut rates by another quarter point!

Torsten Slok, Chief Economist at Apollo Management, said hedge funds even started discussing whether the Fed's next step should be to raise interest rates.

Robert Brusca, Chief Economist at FAO Economics, expressed confusion over the Fed's stance: "I don't see how the Fed is going to get inflation down to 2% if they're going to start cutting interest rates," adding that they believe that inflation will disappear on its own.

Trump's Return: Could change the Fed's course?

In September, Fed officials projected five rate cuts totaling 125 bps through the end of 2025, down from six cuts forecasted after March's meeting. This would bring the average rate to 5.1% by year-end and 4.1% by 2025.

However, the 19 policymakers, whether voting members or not, adjusted their expectations in September, predicting rates at 4.4% this year and 3.4% in 2025.

Markets are closely watching the upcoming policymaker report, due after Wednesday's meeting. Expectations include a lower unemployment rate than the September forecast, along with core PCE inflation and GDP growth surpassing previous estimates, which could lead the Fed to adopt a more cautious approach to easing.

The forecasts are unlikely to explicitly include the anticipated political shifts under the incoming White House administration. However, as was the case with the post-election meeting in 2016, discussions are expected regarding the macroeconomic and price implications.

Neovian, with $1.3 trillion in assets under management, ruled out a soft landing scenario, where the US avoids recession with lower inflation next year. It anticipates that potential tariffs could exert upward pressure on inflation.

The key question: Will the Fed end the year with a one-percentage-point decrease in rates compared to last year? Or will Jerome Powell surprise markets with a fixed borrowing cost range as Donald Trump's official inauguration approaches?

Sources: Argaam, Federal Reserve Website, FedWatch Tool, Market News, US Bank, MarketWatch