What pushed the Fed to make its dovish December pivot?

There is no question that the US Federal Reserve’s unexpectedly dovish pivot in December added fuel to the stock market rally. Emboldened by Fed chair Jerome Powell’s comments, the market began pricing in at least three more rate cuts than it had before the meeting. That, in turn, justified another surge in stock prices. Surely, the Fed must have some inkling of the effects of its words on the market.

Stock market gains will create a positive wealth effect and boost consumption, while expectations for short-term rate cuts also drove down longer-dated Treasury yields, which are the benchmark for the pricing of almost all commercial borrowings, including mortgage rates. The resulting looser financial conditions could lead to resurgent inflation and complicate the Fed’s objective to bring inflation down below 2%.

So, why did Powell say what he did, a complete reversal from his previous higher-for-longer narrative? As recent as early December, the Fed chair was insisting that it would be premature to speculate on when policy might ease. By mid-December, rate cuts were something that “begins to come into view” and “clearly is a topic of discussion”. What changed in those two weeks is less clear.

There was no evidence of imminent recession. In fact, recession fears have all but evaporated. A soft landing became the overwhelming consensus. The latest Atlanta Fed’s GDPNow estimates a significantly more robust 4Q2023 real GDP growth of 2.7%, up from 1.2% over the two-week period. US retail sales for November came in stronger than expected. The latest unemployment reading dropped to nearhistoric lows, of 3.7% and lower than the forecast 3.9%. The economy added 199,000 jobs in November, again slightly better than the market expected. Average hourly earnings, a key inflation indicator, increased 4% y-o-y. Indeed, there were few changes in the Fed’s own economic projections from the last one made in September (Table 1 in main article).

This begs the question: Why the hurry to cut rates if the economy is holding up so well? Does the Fed know something it is not telling? Or was it due to political pressure, as some are suggesting, with the November 2024 presidential election looming? Stock market performance is a highly visible metric, and often viewed as a proxy for economic strength. Prosperity (perceived or real) tends to favour the incumbent while recession will favour the challenger. Case in point: President Joe Biden flaunted the stock market’s record highs in his recent campaign video. (Scan the QR codes for selected articles on the subject.)

The Fed is an independent institution and does not answer to the White House. Nonetheless, the Fed chair may not be entirely immune to some heat either, even if the central bank ultimately does what is necessary.