We are three weeks away from our last meeting of the year. Despite frequent signals from Fed officials that they will wait patiently for more evidence of cooling inflation, investors have become more optimistic, with interest rate futures indicating that further Fed rate hikes have been ruled out and investors focused on the possibility of a cut as early as May next year.

With the easing of financial conditions becoming more apparent as long-term Treasury yields fall, how to put the brakes on market enthusiasm may be a challenge for the Fed, which is concerned about the two-way risks of policy.

Expectations of a soft landing have risen

Earlier this month, the Fed decided to keep the federal funds rate at its highest level in nearly 22 years for the second time in a row.

The statement implied that it would leave the door open for another rate hike in the future if inflation does not continue to slow. That means the Fed will continue to decide, on a data-by-data basis, whether further action is needed at its next meeting.

According to Fed Chairman Jerome Powell, lowering inflation may require below-trend economic growth and softening labor market conditions. Now the data seems to be moving in the direction he envisioned. The labor market finally seems to be loosening. The U.S. economy added 150,000 jobs last month, the lowest in nearly two and a half years, while the unemployment rate ticked back up to 3.9 percent and initial jobless claims rebounded to a three-month high.

National retail sales, a key component of consumer spending, fell 0.1 per cent last month, the first decline since April. At the same time, service sector expansion is close to returning to a tipping point. The ISM data showed the U.S. non-manufacturing PMI slowed to a five-month low. The Atlanta Fed's GDPNow tool shows the U.S. economy grew 2.0% in the fourth quarter, a sharp slowdown from 4.9% in the third quarter.

This has also raised expectations that the Federal Reserve will end interest rate hikes. Affected by this, the strong US dollar index this year has basically reversed its gains, falling nearly 3% since November, the largest monthly decline in nearly a year. Oanda senior market analyst Craig Erlam said in an interview with the first financial reporter that from the anti-inflation trend and economic cooling, the policy effect of this round of interest rate hikes has finally begun to show, and the Federal Reserve has more and more reasons to continue to be patient.

The prospects for a soft landing have brightened. According to a survey by the National Association of Business Economists (NABE), 70 per cent of economists said there would be no recession in the next year.

Goldman Sachs sees a 15 percent chance of a recession in the next 12 months, forecasting GDP growth of 2.1 percent in 2024. "The conditions are in place for inflation to return to target and the worst of the monetary and fiscal tightening has passed." "The report said.

Fed reacts to calls to cut interest rates

Fed funds futures show that while betting on the end of Fed rate hikes, investors have shifted their sights to rate cuts. The latest pricing suggests a more than 50 per cent chance of a rate cut next May and more than 80 per cent chance of a cut in June.

Institutions are also bracing for policy inflection points. Morgan Stanley believes the Fed will cut rates by 25 basis points for the first time in June 2024, four times throughout the year, and at every meeting in 2025. Bank of America also expects the Federal Reserve to start cutting interest rates in June next year and then once a quarter.

It is worth noting that compared with the optimism of the outside world, the Federal Reserve has not made any substantive statement on the issue of interest rate cuts. Powell has also tamped down speculation over the past two years, most recently during a panel discussion at the International Monetary Fund this month. He said continued progress towards the 2 per cent target was uncertain and inflation data could sometimes be deceptive.

On the 21st local time, the Federal Reserve will release the minutes of last month's rate-setting meeting, and the outside world will focus on the details of the policy decision discussion, especially the threshold for potential interest rate hikes.

Erlam told China Business that he believed the minutes would show the Fed continued to highlight inflation risks and mention the possibility of a potential rate hike. For the Fed, prices are still not to be taken lightly, core inflation remains close to 4%, and judging from the trend of rent and service prices, it may be difficult to fall below 3% in the first half of the year. "Even without further rate hikes, the Fed will need to keep rates high for some time and wait patiently for inflation to move further towards its 2 per cent medium-term objective, meaning the FOMC is still far from declaring victory." He told reporters.

Judging from recent statements by a number of officials, the Fed appears to have seen a shift in market expectations. Boston Fed President Collins said last week that the Fed must be patient and decisive, it will not give up the option of raising interest rates, the key is to really follow through.

Pricing in the expectation of a rate cut has sent mid - and long-term Treasury yields sharply lower this month. The benchmark 10-year Treasury note fell below the 4.50 percent mark, down more than 60 basis points from its early month high. This also partly reflects the easing of financial conditions, with expectations of improved liquidity behind the recent stock market rally driven by improved risk appetite. For the Fed, policy risks could thus shift to understrength, leading to an inflation relapse.

Bob Schwartz, senior economist at Oxford Economics, said in an interview with the first financial reporter that the next major policy risk of the Federal Reserve is still to raise interest rates, and the warning of officials is to avoid the outside world in advance of the end of the interest rate hike cycle. He believes market expectations of a rate cut next year are too optimistic.