Fed Officials Are Talking About 3 Scenarios. Here’s What They Mean for Rates.

The Federal Reserve is as data-dependent as ever these days. Instead of offering firm forecasts—or even best guesses—officials are acknowledging that there’s a range of potential outcomes ahead, and they aren’t sure which way the chips will fall.

Several Fed governors and regional bank presidents have recently described a handful of options for the U.S. labor market and inflation in the second half of 2024, and what the appropriate monetary policy response would be in each case.

One path sees an orderly decline in inflation and a still-solid labor market that allows the Fed to slowly back off of restrictive monetary policy. That could mean a so-called soft landing and a single quarter-point rate cut this year. Another path involves a more pronounced slowdown in the U.S. economy, with a spike in unemployment, that could bring two or more cuts. A third path sees inflation and growth remaining hot, and higher-for-longer interest rates—with hikes potentially back on the table.

“Being definitive and predetermined is not that helpful,” San Francisco Fed President Mary Daly said Monday. “What is helpful, is planning: Evaluating scenarios that could play out and understanding how policy should respond. In other words, to be appropriate, policy has to be conditional and we have to think in scenarios.”

“In my view, we should consider a range of possible scenarios that could unfold when considering how the [Federal Open Market Committee’s] monetary policy decisions may evolve,” Fed Governor Michelle Bowman added today.

Just plug in the economic data as it comes in and you’ll know what path interest rates will take.

The Choose-Your-Own-Adventure approach is in a response to the volatile and confounding data of the postpandemic period.

“We are still surrounded by an air soaked with uncertainty: there are a host of risks and known unknowns,” said Philadelphia Fed President Patrick Harker on June 17. “Data have been what I would describe as ‘choppy.’”

The FOMC has held its target for the federal-funds rate at a range of 5.25% to 5.50% since July 2023. Inflation decelerated sharply in the second half of 2023, then stalled sideways in the first half of this year. The labor market has cooled from its overheated levels post pandemic, but remains tight by historical standards.

So, what comes next?

“One scenario is the possibility that persistently high inflation durably increases inflation expectations,” Fed Governor Lisa Cook said on Tuesday. “Such a risk would imply keeping monetary policy restrictive for longer. Another scenario would be that the economy and labor market weaken more sharply than expected…In that case, monetary policy would need to respond to such a threat to the employment side of the dual mandate.”

A few officials have a potential rate hike as the next move still in the cards. St. Louis Fed President Alberto Musalem described a real risk of inflation remaining stuck above the Fed’s target or even reaccelerating.

“Should evidence of these alternative inflation scenarios begin to materialize, I would support an additional firming of monetary policy,” Musalem said on June 18. “To be clear, I do not view inflation getting stuck or rising as the most likely scenarios. But if progress toward achieving 2% inflation stalls or reverses, I believe it would be appropriate for the committee to act promptly to ensure that high inflation does not become entrenched.”

Interest-rate futures market pricing on Tuesday implied a nearly 65% chance of a quarter-point decrease in the target at the FOMC’s September meeting, and the greatest odds of two cuts by the end of 2024. The median forecast in Fed officials’ June projections implied one quarter-point decrease this year.

September is the next live meeting for the FOMC. There will be three months worth of jobs, inflation, and growth data between now and then. Just fill in the blanks.

Write to Nicholas Jasinski at [email protected]