New Federal Reserve rate-cut projections issued tomorrow at 2 p.m. seem sure to cause an immediate S&P 500 reaction. If the status quo of three Fed rate cuts remains in place, that could spark an initial relief rally. However, if policymakers pencil in one fewer rate cut for 2024, some selling pressure seems like a given.
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But just how much pressure stocks come under in the latter scenario may depend on how chair Jerome Powell explains why at least one less Fed rate cut is in order. The discussion likely will get into two words that Powell only used once at his Jan. 31 news conference: financial conditions.
At that time — before January and February data showed an uptick in inflation — Powell brought up financial conditions when asked why it was too soon to start cutting even though the Fed’s 5.25%-5.5% target rate looked extremely tight at about 3 percentage points above expected inflation for the year ahead.
But the stakes may be higher now if the Fed starts talking not just about delayed rate cuts, but fewer rate cuts.
Financial Conditions And Fed Rate Cuts
At the January news conference, Powell explained that policymakers “look at more than just the fed funds rate. We look at — broadly — financial conditions.”
Fed policy works by affecting financial conditions throughout the economy, from stock prices to the dollar’s exchange rate to borrowing rates and demand for credit. No matter how high rates are, the Fed may have more work to do if those conditions are too robust, contributing to stronger economic growth.
Fed minutes from the January meeting, released Feb. 21, underscored that concern: “Several participants mentioned the risk that financial conditions were or could become less restrictive than appropriate, which could add undue momentum to aggregate demand and cause progress on inflation to stall.”
Since then, the S&P 500 has tacked on another 5%, bringing its gain since late October to 25%. That helps explain why the Chicago Fed Nation Financial Conditions Index slipped in the week through March 8 to its lowest level — reflecting the easiest financial conditions — since before the Fed started hiking interest rates in February 2022.
The Fed doesn’t target any particular level for the S&P 500, but the AI-fueled stock market rally is a key reason behind the overall loosening of financial conditions. The risk: any implicit connection between a stingier rate-cut outlook and the roaring bull market could put a short-term ceiling on the S&P 500 until inflation ebbs further.
Real Interest Rate
There’s also another possible explanation for why the Fed may signal it needs to keep interest rates higher for still longer. As Powell admitted at the January news conference, “We don’t know with great confidence where the neutral rate of interest is at any given time.”
The message implied that Fed policy might not be as tight as it looks. That might result from changes in the economy raising the neutral rate of interest — the rate that neither boosts nor restricts economic growth.
Since mid-2019, Fed projections have pegged the long-term neutral interest rate at 2.5%, or just a half percentage point above the target rate of inflation. The Fed’s estimate of the neutral rate had fallen from around 4% since mid-decade.
However, numerous Wall Street economists and bond market specialists have indicated they think the neutral rate isn’t 2.5%, but likely above 3%. If the Fed begins to bump up its estimate of where the neutral rate is with its new projections, that could provide a partial rationale for why fewer rate cuts are in order.
Fed Chair Powell
Yet if the Fed pencils in one less rate cut, Powell is likely to help that medicine go down with his usual dose of optimism. The Fed chair is sure to downplay the importance of any change in the projections, saying that the economy is hard to forecast and the policy will depend on the data.
He may also note that a shift in the opinion of just a couple of individual policymakers altered the rate-cut outlook, meaning there was less to the change than met the eye. Of course, that wouldn’t be true if a bunch of Fed policy committee members pencil in a more hawkish outlook.
S&P 500
The S&P 500 rose 0.5% in Monday stock market action to end its first three-session losing streak since Jan. 4. The S&P 500 closed just 0.5% off its all-time closing high.
Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
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