As expected, the Federal Open Market Committee (FOMC) decided to keep its key interest rate, the federal funds rate, unchanged at 5.25%–5.50%. We believe lower-than-expected price data and the labor market’s gradual weakening mean we’ve probably seen the last of interest rate hikes.

Despite the good news on inflation, the Federal Reserve’s (Fed’s) rhetoric will likely remain careful to avoid sounding too dovish too soon. Any resurgence in price pressures due to loose monetary policy would harm the Fed’s credibility. While core inflation has fallen further since the Fed’s November meeting, it’s still at 4.0%—double the Fed’s long-term target. Fourth-quarter economic growth is expected to remain positive, although it’s likely slowed significantly from strong third-quarter results. Also, the labor market has shown more signs of slowing from a very strong third quarter, and higher-frequency growth indicators, like purchasing managers’ indexes, have stabilized at a level consistent with low growth.

As long as core inflation (which excludes food and energy prices) continues to trend lower, the Fed will likely be comfortable staying on hold. Core goods’ impact on U.S. inflation has become deflationary in 2023 while services (excluding rents) and more volatile items like food and energy have started to roll over. Inflation’s breadth (how many goods and services are increasing at the same time) has come down further—as has inflation persistence (how sticky inflation will be). The short-term interest rate market has aggressively moved since the last Fed meeting and now expects a string of rate cuts starting as early as May 2024 followed by three more rate cuts by the end of 2024.

Our base case is for the Fed to hold until inflation and growth data both weaken enough to justify less restrictive monetary policy. Our inflation framework measures inflation’s level (how high it is), breadth, and persistence (how sticky it is). All three components have rolled over now, which is good news for the Fed. Nominal yields—and, to a lesser degree, real yields—will likely fall further, and the U.S. dollar is expected to weaken from here as the interest rate differential between the U.S. and other global markets shrinks.

We continue to favor bonds, which benefit from falling growth and falling inflation. We also continue to like equities—despite a short-term struggle with lower earnings guidance, any relief from perceived looser monetary policy would likely support equity prices in the medium term.

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