Preview of the Federal Reserve's interest rate decision: December is expected to continue to stand still, and the four major highlights are the first to see

The central bank's year-end drama is about to debut, and the Federal Reserve is leading the "Super Week Thursday" blockbuster!

At 14:00 EST on Wednesday, December 13 (03:00 a.m. Beijing time on Thursday, December 14), the Federal Reserve will announce its last interest rate decision of the year, followed by Fed Chairman Jerome Powell's monetary policy press conference.

Wall Street's major investment banks are unanimous in their view that the Fed will continue to hold its ground and keep interest rates unchanged for the third time in a row. For this meeting, the focus of the market will be on the Fed's last quarterly economic outlook SEP and dot plot, which will be an important clue for the outside world to assess the Fed's future policy path.

At the September interest rate meeting, the Fed judged the endpoints of interest rates in 2023 and 2024 to be 5.6% and 5.1% (implying one rate hike in 2023 and two rate cuts in 2024), which was more hawkish than the four rate cuts expected before the June meeting and the market meeting, triggering significant market volatility.

Before this meeting, the market sentiment is more optimistic, according to the latest CME Fed Watch data, the Fed will keep interest rates unchanged in the range of 5.25%-5.50% in December with a probability of 98.4%, and has now bet that the Fed will cut interest rates five times in 2024 for a total of 125 basis points, and will start acting as early as May next year.

There is a difference of nearly 100 basis points between the pricing of the interest rate market and the Fed's September dot plot for the end of next year.

Eighteen hours after the Fed's interest rate decision, the ECB will also put on its last "show" of 2023.

The ECB's current situation is quite similar to that of the Fed - inflation data is also falling rapidly, and market expectations for the ECB to cut interest rates next year continue to rise, and the ECB has not relented.

The consensus is that the ECB will also not make any substantive moves at the last meeting of the year. On the one hand, inflation in the eurozone has recorded the lowest growth rate of 2.4% in 28 months, and on the other hand, European economic data is generally weak.

Money markets are fully pricing in the expectation that the ECB will cut interest rates six times in 2024 for a total of 150 basis points, which will bring the key interest rate in the eurozone to 2.5% in 2024, and the ECB is expected to start a rate cut cycle in April next year.

Fed: How will the year-end drama play out?

With the market almost universally believing that the current rate hike cycle has come to an end and that the Fed may hold its ground in this week's rate decision and cut rates sharply from next year, the debate now for Wall Street has become: when exactly will the Fed start cutting interest rates, and how much?

Although the Fed's median dot plot in September showed that the Fed would raise interest rates by 50bp at the end of 2023, with a 50bp cut in 2024, the market began to bet that the federal funds rate would be reduced to a level of 4%-4.25% by the end of next year, against the backdrop of a significant cooling of US inflation in recent months, with a rate cut of 125bp.

Aspect 1: How to reconcile the huge divergence between the Fed and the market?

Against the backdrop of stubborn core inflation and a still hot job market in November, the market only slightly lowered its expectations for a Fed rate cut next year to about 108 basis points, a far cry from the Fed's current rate cut expectations.

According to Jonathan Millar, a former economist at the Federal Reserve's Department of Research and Statistics and now senior U.S. economist at Barclays, the market's current expectations are too optimistic. The Fed is still repeatedly emphasizing that interest rates will remain high for a long time, so he believes that the rate cut cycle will not officially start until the end of next year, that is, only 25 basis points by the end of next year.

Wells Fargo strategist Chris Harvey warned in an interview yesterday that the market's optimism is "overdone":

We expect Fed Chair Jerome Powell to try to convince markets that policy will not ease anytime soon, but we doubt that market participants will once again believe the Fed's rhetoric and reduce bets on rate cuts next year.

Analysts believe that the market's judgment on whether the Fed is hawkish or dovish will focus on the update of the "dot plot".

Michael Gapen, chief U.S. economist at Bank of America, expects the dot plot to show that the rate cut is expected to be 75-100bp in 2024, down from the current market expectation of 108bp. However, since the market consensus expectation has been more dovish than the Fed's SEP since the start of the current interest rate hike cycle, even if the SEP rate cut in December is lower than market expectations, it may not have much impact on the market.

Goldman Sachs and Wells Fargo believe that the median interest rate will be lowered to 4.875% in 2024 from 5.125% in September, which is equivalent to two rate cuts.

Aspect 2: How to adjust the GDP growth forecast and PCE inflation forecast?

Although the US November CPI data showed a slight rebound in the core CPI month-on-month growth in November, and stubborn service inflation, coupled with the unexpected decline in the non-farm unemployment rate in November to 3.7% released last week, the market generally believes that economic growth and inflation are expected to be revised downward year-on-year next year, while the unemployment rate may be revised upward.

New York Fed President Williams previously predicted that the Fed's most important inflation measure, the PCE, would fall to around 2.25% in 2024 and close to 2% in 2025. At the same time, he expects the economy to slow down to 1.25% next year.

Morgan Stanley's team noted in the report that PCE will fall to 1.8% in September next year, below the Fed's 2% target, while the economy does not experience a recession. Alan Detmeister, an economist at UBS, said that the current resolution of supply problems is gradually causing prices to gradually fall, and the US inflation rate is expected to fall to 1.7% in the fourth quarter of 2024.

Aspect 3: How much is the difference of opinion within the Fed?

Unlike previous meetings, a number of Fed officials released "dovish signals" before this meeting.

Fed Governor Christopher Waller, as a hawkish and influential voice within the Fed, surprised the outside world with his previous "dovish" speech:

I am increasingly confident that the current policy will do a good job of slowing economic growth and bringing inflation back to 2%.

Most officials supported standing still. Recently, Powell reiterated that it is too early for monetary policy to be tight enough, and that the risk of insufficient tightening and excessive tightening is in a more balanced state.

At the same time, Fed Governor Bowman and Cleveland Fed President Mester were more hawkish and expected to raise interest rates again this year. The market widely expects that the divergence within the Fed will not affect the final vote.

Aspect 4: What changes to the Fed's monetary policy statement are worth noting?

Analysts generally believe that there may be some wording adjustments in the Fed's assessment of employment, inflation, housing, and overall economic growth. Bank of America believes that the Fed may abandon the "further tightening" narrative and simply emphasize its commitment to bringing inflation down to 2%.

Goldman Sachs, on the other hand, believes that the statement may also exclude descriptions of tighter financial conditions and may adjust some other subtle changes that were previously used to express the propensity for interest rate hikes.

It can be seen from the degree of tightness of the financial conditions indicator compiled by Goldman Sachs that the current financial conditions in the United States have fallen back to the level of June last year.

Analysts believe that Powell's statement at the press conference may remain neutral, continuing to emphasize "relying on data" to deal with the changing economic and market outlook, which also means that the market's overly optimistic interest rate cut expectations are difficult to be fully corrected.

ECB: Will it be the first to start the rate cut cycle?

At 21:15 on the evening of December 14, Beijing time, the European Central Bank will announce a new round of interest rate decisions, and the market generally believes that the European Central Bank's interest rate hike has entered the key point, and will cut interest rates earlier and faster than the Federal Reserve. At the same time, the European Central Bank's next move on the Emergency Pandemic Purchase Program (PEPP) will be the focus of market attention.

Aspect 1: How should the ECB manage expectations?

Recently, in the context of a sharp cooling of European inflation data, the European Central Bank Governing Council is gradually sending a dovish signal to the market that interest rate hikes have stopped.

Earlier in December, Isabel Schnabel, who is seen as the "eagle" of the ECB's Governing Council, said that the decline in inflation was "significant and encouraging" and that the ECB might not raise interest rates further. The euro overnight index swap showed that the market expects the European Central Bank to start cutting interest rates in April next year, and has cut interest rates five times as of October (data is only updated to October). Earlier than the market's bets that the Fed will start cutting interest rates in May next year.

The market believes that ECB President Christine Lagarde may try to temper market expectations that the ECB will cut interest rates by 25 basis points in April next year.

Recent data showed that inflation in the eurozone rose 2.4% year-on-year in November, falling to its lowest level in more than two years. While economic data showed further signs of weakness, the final Markit composite PMI in the Eurozone for November came in at 47.6, better than market expectations of 47.1 and still below the boom-wither line of 50.

Despite the slowdown, in order to avoid overly loose markets, Lagarde is following Powell's example of "raising interest rates with his mouth" to "manage expectations" in the market, vowing to bring inflation back to target:

"The battle is not over, and we certainly will not declare victory. ”

Bundesbank President Joachim Nagel also recently warned the market that it would be a "mistake" to start easing monetary policy too early. Similarly, council member Gabriel Makhlouf said he could not rule out the possibility of "going to the next level" and that it was "too early" to start talking about rate cuts.

Aspect 2: Will the ECB withdraw from the PEPP reinvestment program?

Analysts generally believe that the market's rising expectations for the ECB's interest rate cut are affecting the management committee to accelerate the withdrawal of the anti-epidemic emergency bond purchase program (PEPP) arrangement. At last month's interest rate meeting, the ECB said that the PEPP reinvestment plan will continue until at least the end of 2024. Currently, PEPP's portfolio size is €1.7 trillion (about $1.9 trillion).

Goldman Sachs, Barclays and Société Générale believe that the ECB will accelerate its exit from PEPP in a similar way to initiating quantitative tightening by canceling the asset purchase program (APP). This could mean that the ECB will announce at its last meeting of the year that it will reduce its PEPP reinvestment plan from the end of the first quarter of next year and communicate more details at its next policy meeting in January.

Lagarde said last month that the PEPP plan would be reassessed soon, and several members of the ECB's governing council have already expressed support for the idea of "starting to taper PEPP earlier". Last week, Holzmann, the governor of the Austrian central bank, one of the governing councils, said he was in favor of discussing the matter at the December interest rate meeting and gradually reducing reinvestment from March next year.