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

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In the “fog” caused by the US government shutdown leading to missing critical economic data, the Federal Reserve may make another key interest rate decision this year. Markets generally expect the FOMC to cut interest rates again and may also announce the end of its balance sheet reduction plan to address labor market risks and liquidity pressures in money markets.

At 2:00 am Beijing time on Thursday, the Federal Reserve FOMC will announce its interest rate decision, followed by a press conference at 2:30 with Fed Chair Jerome Powell speaking. According to money market pricing and Reuters surveys, a 25 basis point rate cut is almost a certainty. This anticipated move stems mainly from policymakers’ increasing concern about downside risks in the job market, even as inflation pressures persist.

Meanwhile, as signs of liquidity tightening have appeared recently in the money markets, most major banks, including Goldman Sachs and JPMorgan Chase, expect the Fed to announce the end of its balance sheet reduction plan at this meeting. This move is intended to stabilize the financial system and avoid a repeat of the 2019 repo market turmoil.

However, due to the ongoing US government shutdown causing a lack of key economic data, Powell is expected not to give clear forward guidance regarding policy for December. Steven Englander, Standard Chartered Head of North America Macro Strategy, said there has been “not much to shift the view” since September, when policymakers hinted at a 25 basis point rate cut each in October and December. Goldman Sachs economists believe the bar is high for a December rate cut, unless alternative data provides sufficient reason, and current data does not provide such a signal.

A 25 Basis Point Rate Cut is Almost Certain

This Federal Reserve rate cut decision is mainly based on ongoing concerns about risks to the labor market. Powell stated earlier this month that the Federal Open Market Committee remains focused on threats facing the labor market. Although core CPI rose 3% year-on-year, a whole percentage point above the target, last week’s mild inflation report may make the Fed's hawks on inflation hold off for now.

Krishna Guha, Evercore ISI Global Policy and Central Bank Strategy Head, states: "Labor market 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 focusing on employment, “returning the Fed’s policy stance to neutral.”

Federal funds futures show investors consider a 25 basis point cut almost a fait accompli. But the high likelihood of a rate cut doesn’t mean policymakers have reached consensus on the interest rate outlook. A considerable number of officials, while acknowledging risks to the labor market, continue to express concerns about inflation. Some have noted that prices in certain sectors, such as services, remain stubbornly high; these sectors are less affected by tariffs.

Fed Governor Miran is expected to vote again for a 50 basis point cut. In recent remarks, he said that a 25 basis point step is too slow, but he does not think there is a need to exceed a 50 basis point cut. Kansas City Fed President Jeff Schmid is seen as a likely dissenting vote in favor of holding rates steady.

FOMC Members’ Divisions Widen, Labor Market Becomes Focus

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

Concerns about employment are intensifying. ING analysts warn the US economy is in a “low hiring, low firing” situation, but there is a clear risk of evolving into “no hiring, need to fire.” If this happens, it will jeopardize the Fed’s core goal of “maximum employment.” Minutes from the September FOMC meeting also show most participants believe downside risks to employment have increased.

Although Fed officials believe the labor market is roughly balanced between labor demand and supply, they also worry that companies may further decrease hiring or resort to layoffs. This risk has been highlighted by Amazon’s recent layoff announcement and increases in state unemployment benefit claims. State employment agencies are still collecting and publishing weekly jobless claims data, providing a barometer for labor market health.

In addition, divisions among policymakers may further surface at this meeting. Some members are expected to dissent, such as Governor Miran, who has recently stated support for a larger 50 basis point cut. Meanwhile, some more inflation-worried hawkish members may prefer to keep rates unchanged. This division reflects the ongoing debate within the committee about whether to prioritize employment risks or inflation risks.

Liquidity Tightening May Prompt Fed to End Balance Sheet Reduction

Besides a rate cut, another major focus of this meeting is whether the Fed will announce an end to its balance sheet reduction plan. Most Wall Street banks, including Goldman Sachs and JPMorgan Chase, expect the FOMC to act due to signs of liquidity strain in money markets in recent days.

Recently, the Secured Overnight Financing Rate (SOFR) briefly breached the top of the federal funds rate target range, demand for the New York Fed’s overnight reverse repo tool dropped sharply, while usage of the reverse repo tool increased. These signals point to bank system reserves approaching the lower bound of “ample” level, raising concerns of a repeat of the 2019 repo market crisis.

To avoid excessive liquidity exhaustion, analysts expect the Fed will announce the halt of its monthly $5 billion Treasury runoff, but may continue allowing mortgage-backed securities (MBS) to passively roll off. However, this decision may also face internal disagreements, as Governor Bowman and others have previously stated a preference for keeping the balance sheet as small as possible.

The Fed is currently allowing $5 billion of Treasuries and $35 billion of Mortgage-Backed Securities (MBS) to run off the balance sheet each month. The Fed may continue to let MBS run off, but begin reinvesting all maturing Treasuries, rather than allowing $5 billion to exit the balance sheet.

In the Data "Black Box," Powell Struggles to Give Clear Guidance

Because the government shutdown has resulted in missing official data, markets expect Powell to avoid providing explicit forward guidance about December policy at the press conference. Lack of reliable employment and inflation data makes it more difficult for the Fed to make judgments.

Goldman Sachs economists believe if Powell is asked about action in December, he may reiterate the path implied by the September meeting “dot plot” — namely, one more rate cut this year.

Goldman Sachs maintains its assessment of the likelihood of a December rate cut, mainly for three reasons: First, the September “dot plot” set the third rate cut as a baseline, and the market has fully priced this in. Second, the Fed prefers to complete a “three-cut” rate cycle. Third, when the December meeting arrives, forthcoming labor market data may be distorted or incomplete due to the government shutdown, making it hard to send a clear “all-clear” signal; skipping a well-anticipated rate cut would thus be awkward.

Goldman Sachs notes that broader data show the labor market is clearly weaker than before the pandemic. Imminent postponed DOGE resignations may result in a negative October jobs report and somewhat drag down November numbers. Even if this is old news, skipping a rate cut that has already sent a signal would appear especially awkward soon after. Moreover, the government shutdown has disrupted October data collection, which may also interfere with November numbers to some extent, potentially leading to distortions or missing data and making labor market signals available before December less reliable.

Overall, with a data vacuum, the Fed is essentially “wading across the river by feeling for stones.” Investors will closely watch Powell’s description of current economic conditions and any subtle hints he gives about labor market risks and policy paths, to judge whether the tone of easy policy will persist in the visible future.

Risk Warning and DisclaimerThe market has risks; investment needs caution. This article does not constitute personal investment advice, nor does it consider any individual user's specific investment objectives, financial situation, or needs. Users should consider whether any opinions, views or conclusions in this article suit their specific circumstances. Investing based on this article is at your own risk. ```