Tonight, will the Federal Reserve launch a "rate cut + stop balance sheet reduction" combo?

The market generally expects that, in response to downside risks in the labor market, a 25 basis point rate cut is almost a certainty. Meanwhile, due to recent signs of liquidity tightening in the money market, the Federal Reserve may announce the suspension of its balance sheet reduction plan. As the ongoing U.S. government shutdown has led to a lack of key economic data, Powell is not expected to provide clear forward guidance on the policy path for December. Goldman Sachs believes another rate cut in December remains possible.

Written by: Zhao Ying

Source: Wallstreetcn

Amid the “fog” caused by the U.S. government shutdown and the resulting lack of key economic data, the Federal Reserve may make another crucial rate decision this year. The market widely expects the FOMC to cut rates again and possibly announce the end of its balance sheet reduction plan to address labor market risks and liquidity pressures in the money market.

At 2:00 a.m. Beijing time on Thursday, the Federal Reserve FOMC will announce its rate decision, followed by a press conference by Fed Chair Powell at 2:30 a.m. According to money market pricing and a Reuters survey, a 25 basis point rate cut is almost a foregone conclusion. This anticipated move is mainly driven by policymakers’ growing concerns over downside risks in the job market, despite persistent inflationary pressures.

Meanwhile, due to recent signs of liquidity tightening in the money market, most major banks, including Goldman Sachs and JPMorgan, expect the Federal Reserve to announce the suspension of its balance sheet reduction plan at this meeting. This move aims to stabilize the financial system and avoid a repeat of the 2019 repo market turmoil.

However, due to the ongoing U.S. government shutdown and the resulting lack of key economic data, Powell is not expected to provide clear forward guidance on the policy path for December. Steven Englander, Head of North America Macro Strategy at Standard Chartered, said that since September “there hasn’t been much to change views,” when policymakers indicated that 25 basis point cuts were possible in both October and December. Goldman Sachs economists believe the bar for a December rate cut is high unless alternative data provides sufficient justification, which current data does not.

A 25 Basis Point Rate Cut Is Almost Certain

This Fed rate cut decision is mainly based on continued concerns over labor market risks. Earlier this month, Powell stated that the Federal Open Market Committee remains focused on threats facing the labor market. Although core CPI rose 3% year-on-year, a full percentage point above the target, last week’s mild inflation report may allow the Fed’s inflation hawks to remain on the sidelines for now.

Krishna Guha, Head of Global Policy and Central Bank Strategy at Evercore ISI, said: “Labor data continues to play a bigger role in the debate.” As long as officials are comfortable with inflation expectations and the level of wage and service price pressures, Powell can continue to focus on employment, “returning the Fed’s policy stance to neutral.”

Federal funds futures show that investors see a 25 basis point rate cut as almost a certainty. But the high likelihood of a rate cut does not mean policymakers are united on the rate outlook. While many officials acknowledge labor market risks, they continue to express concerns about inflation. Some also point out that certain sectors of the economy, such as services, continue to see stubborn price increases, and these sectors are less affected by tariffs.

Fed Governor Miran is expected to vote again in favor of a 50 basis point rate cut. In recent remarks, he noted that a 25 basis point pace is too slow, but he does not see a need to move by more than 50 basis points. Kansas City Fed President Jeff Schmid is seen as a possible dissenting vote in favor of keeping rates unchanged.

FOMC Members’ Divergence Widens, Labor Market Becomes the Focus

Although the rate cut itself is not in much doubt, internal divisions within the FOMC are growing, with the focus shifting from inflation to the labor market.

Concerns over employment are intensifying. Analysts at ING warn that the U.S. economy is currently in a “low hiring, low firing” state, but there is a clear risk of evolving into a “no hiring, layoffs” scenario. If this happens, it would jeopardize the Fed’s core goal of “maximum employment.” Minutes from the FOMC’s September meeting also showed that most participants believe downside risks to employment have increased.

Although Fed officials believe the labor market remains roughly balanced between labor demand and supply, they are also concerned that businesses may further cut hiring or resort to layoffs. This risk has been highlighted by Amazon’s recent layoff announcement and an increase in state unemployment claims. State employment agencies are still collecting and publishing weekly unemployment claims data, providing a barometer for the health of the labor market.

In addition, divisions among policymakers may become more apparent at this meeting. Some members are expected to cast dissenting votes, such as Governor Miran, who recently expressed support for a larger 50 basis point rate cut. At the same time, some more inflation-focused hawkish members may prefer to keep rates unchanged. This divergence reflects the ongoing debate within the committee over whether to prioritize employment risks or inflation risks.

Liquidity Tightening May Prompt the Fed to Halt Balance Sheet Reduction

Besides the rate cut, another major focus of this meeting is whether the Fed will announce the suspension of its balance sheet reduction plan. Most Wall Street giants, including Goldman Sachs and JPMorgan, expect the FOMC to act due to recent signs of liquidity tightening in the money market.

Recently, the Secured Overnight Financing Rate (SOFR) briefly broke above the upper end of the federal funds rate target range, demand for the New York Fed’s overnight reverse repo facility has dropped sharply, while usage of the repo facility has increased. These signals suggest that the banking system’s reserve levels may be approaching the lower end of the “ample” range, raising concerns about a repeat of the 2019 repo market crisis.

To avoid excessive liquidity depletion, analysts expect the Fed to announce the suspension of the $5 billion monthly Treasury runoff, but may continue to allow mortgage-backed securities (MBS) to mature passively. However, this decision may also face internal divisions, as Governor Bowman and others have previously indicated a preference for keeping the balance sheet as small as possible.

Currently, the Fed allows $5 billion in maturing Treasuries and $35 billion in mortgage-backed securities (MBS) to roll off its balance sheet each month. The Fed may continue to allow MBS to roll off, but begin reinvesting all maturing Treasuries instead of allowing $5 billion to exit the balance sheet.

In the Data “Black Box,” Powell Is Unlikely to Give Clear Guidance

Due to the government shutdown and the resulting lack of official data, the market expects Powell to avoid providing clear forward guidance on the policy path for December at the press conference. The lack of reliable employment and inflation data makes it more difficult for the Fed to make judgments.

Goldman Sachs economists believe that if asked about December’s action, Powell may reiterate the path implied by the September meeting’s “dot plot,” which indicated one more rate cut this year.

Goldman Sachs maintains its assessment of the likelihood of a December rate cut, mainly based on three reasons: First, the September “dot plot” has already set a third rate cut as the baseline scenario, and the market has fully priced it in. Second, the Fed tends to complete a “three consecutive cuts” policy cycle. Third, by the December meeting, upcoming labor market data may be distorted or incomplete due to the government shutdown, making it difficult to send a clear “all clear” signal, which would make skipping a widely expected rate cut awkward.

Goldman Sachs points out that broader data sets show the labor market is clearly weaker than before the pandemic. The upcoming DOGE delayed resignations may lead to a negative October jobs report and drag down November data to some extent. Even if this is already known, skipping a signaled rate cut soon after would be particularly awkward. In addition, the government shutdown disrupted October data collection and may also interfere with November data collection to some extent, potentially leading to distortions or missing data, making labor market signals available before December less reliable.

Overall, during this data vacuum period, the Fed can only “cross the river by feeling the stones.” Investors will closely watch Powell’s description of the current economic situation and any subtle hints he gives about labor market risks and the policy path to judge whether the tone of accommodative policy will continue in the foreseeable future.