Key Decisions of the Federal Reserve: When to Cut Interest Rates? When Will "Quantitative Tightening" End?

Last week's surprisingly cool US CPI data was indeed good news for the Federal Reserve and the market.

So, what will happen next? Specifically, when will the Fed start cutting interest rates and when will quantitative tightening (QT) end?

In a recent article by Seth Carpenter, Chief Global Economist at Morgan Stanley, he predicts that interest rate cuts will begin in March 2024. He believes that the downward trend in inflation at that time will give the Fed enough confidence to achieve its inflation target.

As for QT, the Fed has already established general principles: reducing the balance sheet by $65 billion in US Treasury bonds and up to $35 billion in mortgage-backed securities (MBS) each month.

Carpenter notes that in his conversations with colleagues and clients, he often hears the argument that since the Fed ended QT when it began cutting interest rates in July 2019, it is natural to infer that the Fed will end QT when interest rate cuts begin this time.

However, Carpenter disagrees. He cites comments made by Dallas Fed President Lorie Logan regarding how far QT could go, which support his opposing view that QT will continue.

Carpenter points out that Logan was previously the portfolio manager at the New York Fed, making her more knowledgeable about the mechanics of monetary policy implementation than anyone at the FOMC. In her speech, she explicitly stated that she does not believe QT will end in the short term, and in the Q&A session, she explicitly stated that interest rate cuts can happen before QT ends.

Looking back at the FOMC meeting in July 2019, when the Fed cut interest rates by 25 basis points and ended QT ahead of schedule, Carpenter notes that the most crucial argument was that the FOMC had already decided to end QT within two months, so it felt the timing was close enough. Perhaps equally important, the FOMC believed it was easing policy because the inflation rate was too low, so continuing QT would be inappropriate.

This time, Carpenter states that the FOMC does not view next year's interest rate cuts as an easing policy. Instead, against the backdrop of declining inflation and inflation expectations, the Fed sees lowering the nominal policy rate as maintaining a restrictive policy. This view has also been expressed by former Fed Vice Chair Lael Brainard and others.

From this perspective, Carpenter believes that continuing passive balance sheet reduction is not contradictory to maintaining a restrictive policy stance. Of course, Carpenter also points out that if his fundamental view of a soft landing is wrong and the US economy enters a recession, a full-scale accommodative policy would be guaranteed, and the Fed may stop QT.