Economic Monitor – Weekly Commentary
by Eugenio Alemán

Our shadow dot plot for December: An attempt to read FOMC members minds?

December 13, 2024

As we approach next week’s Federal Reserve (Fed) Federal Open Market Committee (FOMC) meeting, a meeting during which the Fed is going to lower interest rates by 25 basis points, it would be interesting to ask ourselves what we would do if we were members of the committee. The question we would ask ourselves before deciding on our position regarding monetary policy going forward would be the following: are current interest rates conducive to the achievement of our inflation target of 2.0% over the long term? The short and quick answer to this question is probably, no, they are not! Although there is a small window early next year where the Fed is going to achieve or be close to achieving its 2.0% target, the environment does not look promising during the second half of the year.

As is always the case in economics, we probably need to qualify our answer because we know that the disinflationary process does not move in a straight line. Thus, the Fed will have to deal with temporary deviations from the disinflationary trend. And today is one of these moments where calm heads should prevail at the Fed. This is the reason we believe that the 25 basis points rate cut in December is baked in. However, the future path for rates has become considerably more difficult.

If Fed officials are watching the same numbers as we are, the later part of the first quarter of 2025 and the first half of the second quarter will look very promising for the path of inflation. There is a chance Fed officials could use this temporary lower inflation trend to cut rates further during the first or second quarter of the year, hoping for the rest of the puzzle to come together and deliver a continuation of the disinflationary process. However, this is very risky, especially due to the risks inherent in the policy changes advanced by the incoming administration. Furthermore, the second half of the year is going to look anything but promising because of base effects, even if there are no new policies implemented by the incoming administration.

In a ‘perfect foresight’ world in which economic actors know what is coming to them, this would not be an issue. But there is no ‘perfect foresight’, and the higher inflation is and/or the longer it remains high the greater the risk of a resetting of inflationary expectations.

Fed officials could use the argument that they look for a 2.0% inflation rate over the long run so short-term deviations shouldn’t be that concerning. But again, the longer it takes for inflation to come back down the riskier it becomes for inflationary expectations. And, as we argued last week, inflation expectations will be the key for policymakers going into 2025, especially because the Fed will have to deal with expectations of higher prices coming from the imposition of tariffs as well as the potential effects of the incoming administration’s proposed immigration policies.

This week’s inflation numbers, both the consumer price index and the producer price index were not a good omen for policymakers, especially because goods prices, which had been contributing considerably to the success of the disinflationary process have started to increase again. This may add to the Fed’s concerns regarding inflation going forward.

We’ll wait to make official changes to our forecast until the outcome of next week’s FOMC meeting, but with all of the (limited) information out, we are ready to interpret what next week’s dot plot decision is probably going to look like. September’s dot-plot had an expectation for rates to come down four times. We think that today’s environment would only allow the Fed to lower interest rates, at most, two times during 2025. This will take the federal funds rate to 3.75-4.00% at the end of 2025. After that, Fed members’ crystal ball may become a bit cloudier, and we expect probably another 50 basis point decline in the federal funds rate during 2026 to take the rate to 3.25-3.50%.

Of course, our view assumes that there are no surprises regarding inflation coming from the incoming administration’s new policies and that there is no external shock that threatens the Fed’s achievement of its inflation target.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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