With U.S. inflation falling sharply from last year's multi-decade highs, the Fed is increasingly likely to cut interest rates in 2024. The Federal Reserve is expected to hold interest rates steady for the third time in a row this week, and Fed Chairman Jerome Powell and his colleagues will use the latest dot plot to give a forecast for cuts in 2024, although perhaps not as many as investors and economists are predicting.

Economists now expect the Fed to cut rates for the first time next June

If the Fed cuts rates at the same time that inflation is lower, that's good news for the economy and investors, meaning the Fed is on the verge of a soft landing, where inflation will fall back to pre-pandemic levels without a recession.

But it is another matter if the Fed cuts rates because the economy has deteriorated sharply, is at risk of a recession, or is already in one, meaning a significant rise in unemployment and a hit to corporate profits from falling demand.

"People want the Fed to cut rates because the economy and inflation have cooled, not because the economy is in a recession," said Diane Swonk, chief economist at KPMG.

The Fed's motivation for cutting rates will affect how much it cuts. If the economy is at risk of a recession or already in one, policymakers are likely to ease policy quickly and sharply, economists say, while easing is likely to be smaller and slower if there is no severe downturn.

Last Friday's November non-farm payrolls report gave few signs of an imminent contraction: the unemployment rate fell to 3.7 per cent from 3.9 per cent in October and non-farm payrolls increased by 199,000, above market expectations of 180,000.

After the stronger-than-expected jobs data, traders in the interest rate market scaled back their expectations for a Fed rate cut. They now see less than a 50 per cent chance that the Fed will cut rates for the first time in March, while betting on cumulative cuts of just over 100 basis points over the next year. Earlier this month, traders were betting on about a 60 per cent chance that the Fed would cut rates for the first time next March, and were predicting a cumulative cut of about 125 basis points over the next year.

Interest rate markets are now pricing in much closer to economists' forecasts. Economists polled last week expect the Fed to cut rates by 100 basis points next year, with the first cut coming in June. More than two-thirds of economists expect the U.S. economy to avoid a recession in 2024; Nearly three-quarters of economists believe the initial rate cut will be in response to falling inflation, rather than because of a shrinking economy.

Nearly three-quarters of economists believe inflation, not employment, will be the catalyst for the Fed's first rate cut

At the same time, the survey also showed that the inflation-wary Federal Reserve will be much more conservative than the market in predicting a rate cut next year when it releases its economic outlook this week. Economists expect the latest dot plot to be released after the Fed's policy meeting to show a cut of just 50 basis points next year.

"We don't expect the dot plot to signal a Fed rate cut in the first half of next year," said Brett Ryan, senior U.S. economist at Deutsche Bank. Strategists Ira F. Jersey and Will Hoffman said: "If the Fed reiterates that it will keep rates at their peak well into next year, then the interest rate market, which is expecting a big cut in early 2024, could be shaken next week."

Powell said early this month that it was "too early" to speculate on when the Fed might ease policy, and he left open the possibility of raising interest rates further if needed to keep inflation in check.

Joseph Lavorgna, chief U.S. economist at SMBC Nikko Securities, pointed out that in the past five Fed tightening cycles, the average time between the last rate hike and the first rate cut was eight months, and the Fed's last rate hike was in July, which means a rate cut is likely next March. "There's still a good chance the Fed will cut rates in March because there are three more jobs reports between now and then," he said. "A deteriorating labor market and softer inflation will prompt the Fed to act."

Lavorgna added that the U.S. presidential election next November could also play a part in the Fed's preference to act early next year to avoid political attention. He expects the Fed to cut rates by 125 basis points next year, with a strong possibility of a bigger cut. He said it would not be enough to prevent a recession, but would limit the damage.

By contrast, Michael Gapen, chief economist at Bank of America, expects the U.S. economy to avoid a recession and that the Fed will cut interest rates by a cumulative 75 basis points over the next year, with the first cut coming next June. He said the decision to cut interest rates would be a response to weakening price pressures rather than a shrinking economy.

Lindsey Piegza, chief economist at investment bank Stifel, was more cautious, saying: "There are a lot of headwinds and uncertainties on the road to a pullback in inflation, and the Fed can't take its foot off the brake yet."