Tonight, the Federal Reserve unleashes a combination of "interest rate cuts + halting balance sheet reduction"?

In the "fog" caused by the U.S. government shutdown leading to the absence of key economic data, the Federal Reserve may make another critical interest rate decision this year. The market widely expects that the FOMC will cut rates again and may simultaneously announce the end of its balance sheet reduction plan to address risks in the labor market and liquidity pressures in the money market.

At 2:00 AM Beijing time on Thursday, the Federal Reserve FOMC will announce its interest rate decision, followed by a speech from Fed Chair Jerome Powell at 2:30 AM. According to pricing in the money market and a Reuters survey, a 25 basis point rate cut is almost a certainty. This anticipated action primarily stems from decision-makers' growing concerns about downside risks in the labor market, despite ongoing inflation pressures.

Meanwhile, due to recent signs of liquidity tightening in the money market, most major banks, including Goldman Sachs and JP Morgan, expect the Federal Reserve to announce the halt of its balance sheet reduction plan at this meeting. This move aims to stabilize the financial system and avoid a repeat of the repo market turmoil seen in 2019.

However, due to the ongoing U.S. government shutdown leading to the absence of key economic data, Powell is not expected to provide clear forward guidance on the policy path for December. Steven Englander, head of North American macro strategy at Standard Chartered, stated that "there has not been much change in the basis for views since September," when decision-makers hinted at potential 25 basis point cuts in October and December. Goldman Sachs economists believe that the threshold for a rate cut in December is high, unless alternative data provides sufficient justification, and current data has not signaled such a need.

A 25 Basis Point Rate Cut Seems Inevitable

The Federal Reserve's decision to cut rates this time is primarily based on ongoing concerns about risks in the labor market. Powell stated earlier this month that the Federal Open Market Committee remains focused on the threats facing the labor market. Although the core CPI rose 3% year-on-year, a full percentage point above the target, last week's inflation report was mild, which may allow the Fed's inflation hawks to remain on the sidelines for now.

Krishna Guha, head of global policy and central bank strategy at Evercore ISI, stated, "Labor data continues to play a larger role in the debate." As long as officials feel reassured about inflation expectations and the levels of wage and service price pressures, Powell can continue to focus on employment, "returning the Fed's policy stance to neutral."

Federal funds futures indicate that investors believe a 25 basis point rate cut is almost a certainty. However, the high likelihood of a rate cut does not mean that decision-makers have reached a consensus on how to view the interest rate outlook. A significant portion of officials, while acknowledging risks in the labor market, continue to express concerns about inflation. Some officials have also pointed out that price increases in certain sectors of the economy, such as services, remain stubborn, and these sectors are less affected by tariffs.

Fed Governor Miran is expected to vote again in favor of a 50 basis point rate cut. In recent remarks, he noted that a 25 basis point move is too slow, but he believes there is no need to act by more than 50 basis points. Kansas City Fed President Jeff Schmid is seen as a potential dissenting vote in favor of keeping rates unchanged

FOMC Members' Disagreements Widen, Labor Market Becomes the Focus

Although there is little suspense regarding interest rate cuts, the internal disagreements within the FOMC are intensifying, with the focus shifting from inflation to the labor market.

Concerns about employment are escalating. Analysts at ING warn that the U.S. economy is in a state of "low hiring, low firing," but there is a clear risk of evolving into "no hiring, layoffs." If this occurs, it would jeopardize the Federal Reserve's core goal of "maximizing employment." The minutes from the FOMC's September meeting also indicated that a majority of participants believe the downside risks to employment have increased.

Although Federal Reserve officials believe the labor market is roughly balanced between demand and supply, they are also concerned that businesses may further cut hiring or resort to layoffs. This risk has been highlighted by Amazon's recent announcement of layoffs and an increase in unemployment benefit applications across states. State employment agencies continue to collect and publish weekly unemployment benefit application data, providing a barometer for the health of the labor market.

Moreover, the disagreements among policymakers may become more apparent in this meeting. It is expected that some members will cast dissenting votes; for instance, Governor Miran has recently expressed support for a larger 50 basis point rate cut. At the same time, some hawkish members who are more concerned about inflation may prefer to keep interest rates unchanged. This divergence reflects the ongoing debate within the committee about whether to prioritize employment risks or inflation risks.

Tightening Liquidity May Prompt the Fed to Halt Balance Sheet Reduction

In addition to interest rate cuts, another major focus of this meeting is whether the Federal Reserve will announce a halt to its balance sheet reduction plan. Most major Wall Street banks, including Goldman Sachs and JP Morgan, expect the FOMC to take action due to recent signs of liquidity tightening in the money market.

Recently, the secured overnight financing rate (SOFR) briefly exceeded the upper limit of the federal funds rate target range, demand for the New York Fed's overnight reverse repurchase tool has significantly declined, while the usage of the reverse repurchase tool has increased. These signals indicate that the reserve levels in the banking system may be approaching the lower limit of "adequate" levels, raising concerns in the market about the 2019 repo market crisis.

To avoid excessive liquidity depletion, analysts expect the Federal Reserve to announce a halt to the monthly $5 billion reduction of Treasury securities, but may continue to allow mortgage-backed securities (MBS) to passively mature. However, this decision may also face internal disagreements, as officials like Governor Bowman have previously indicated a preference for maintaining the smallest possible balance sheet size.

Currently, the Federal Reserve allows $5 billion in maturing Treasury securities and $35 billion in mortgage-backed securities (MBS) to flow out of its balance sheet each month. The Federal Reserve may continue to allow MBS to flow out of the balance sheet but begin reinvesting all maturing Treasury securities instead of allowing $5 billion to exit the balance sheet.

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

Due to the government shutdown leading to missing official data, the market expects Powell to avoid providing clear forward guidance on the policy path for December during the press conference. The lack of reliable employment and inflation data makes it more challenging for the Federal Reserve to make judgments Goldman Sachs economists believe that if Powell is asked about actions in December, he may reiterate the path implied by the September meeting's "dot plot," which suggests one more rate cut this year.

Goldman Sachs maintains its assessment of the likelihood of a rate cut in December based on three main reasons: First, the September "dot plot" has set a third rate cut as the baseline scenario, and the market has fully priced this in. Second, the Federal Reserve tends to complete a "three-rate-cut" policy cycle. Third, by the time of the December meeting, the upcoming labor market data may be distorted or incomplete due to the government shutdown, making it difficult to send a clear signal of "all clear," which would make skipping a widely anticipated rate cut awkward.

Goldman Sachs points out that a broader data set shows the labor market is significantly weaker than pre-pandemic levels. The upcoming DOGE delayed resignations may lead to a negative October employment report and could have some drag on November data. Even though this is old news, skipping a rate cut that has already signaled would be particularly awkward soon after. Additionally, the government shutdown has disrupted data collection for October, which may also interfere with November data collection to some extent, potentially leading to distortions or missing data, making the labor market data signals available before December less reliable.

Overall, in this data vacuum, the Federal Reserve can only "cross the river by feeling the stones." Investors will closely watch Powell's description of the current economic situation, as well as any subtle hints he may provide regarding labor market risks and policy paths, to assess whether the tone of accommodative policy will persist in the foreseeable future