Despite data suggesting that the Federal Reserve's fight against inflation may be nearing completion, policymakers remain cautious about prematurely declaring an end to tightening actions and policy shifts.

The Federal Reserve is preparing to pause its historic rate hikes for a third consecutive meeting next month, but this does not mean they are ready to discuss rate cuts.

On Thursday, San Francisco Federal Reserve President Mary Daly said that interest rates are in a "favorable position" to control inflation, but she is not considering rate cuts at all and believes it is too early to determine whether the Federal Reserve has finished raising rates. Daly will have a voting right on the Federal Open Market Committee (FOMC) next year.

Daly stated that the inflation rate is still too high, and it is "premature" to declare victory over inflation. However, after the Federal Reserve has taken aggressive rate hike measures, she is also not inclined to "overdo" the tightening of monetary policy and believes "patience and vigilance should be maintained." This statement aligns with the views of other policymakers that the Federal Reserve will still keep interest rates unchanged at the next meeting.

New York Federal Reserve President John Williams also said that the Federal Reserve's rate target has reached or is close to its peak. However, if inflationary pressures persist, the Federal Reserve may raise rates again. He expects the inflation rate to drop to 3% this year and to 2.25% in 2024.

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The Federal Reserve has been evading two questions:

Since July, the federal funds rate has been stable at a 22-year high of 5.25% to 5.5%. Policymakers believe this interest rate level is "restrictive" for households and businesses as the Federal Reserve seeks to suppress demand.

However, Federal Reserve officials have been evading two key questions: whether the current interest rates are high enough to reduce inflation to the Federal Reserve's 2% target, and how long the interest rates must be maintained at a "sufficiently restrictive" level.

When the FOMC convenes in mid-December for the last interest rate decision of 2023, these questions will still be unanswered. Despite an increasing number of economic signals indicating that the debate within the Federal Reserve will begin to move in this direction, Federal Reserve officials are still prepared to retain the possibility of further tightening policies while suppressing market expectations for rate cuts.

Part of the reason the Federal Reserve is reluctant to formally announce that the rate hike phase against inflation has ended and to more directly propose conditions for rate cuts is the concern that doing so could lead to a relaxation of the financial environment and undermine the Federal Reserve's efforts to control price pressures.A cause for concern is that as long-term U.S. Treasury yields have retreated, U.S. stocks have surged in recent weeks. Federal Reserve Governor Waller stated on Tuesday that this serves as a reminder that "policymakers must be careful not to rely on this tightening to do our job for us."

Waller also expressed that he is "growing more confident" that monetary policy is in the right place to help the Federal Reserve achieve its inflation target, and suggested that if inflation "persists for a few more months" and slows down, interest rates might decrease. This statement has accelerated the stock market's upward trend.

Now, futures market traders are betting that the first rate cut will occur in May, with the policy rate hovering around 4% by the end of next year, about one percentage point lower than the current level.

The Federal Reserve Lacks Confidence in Persistent Decline of Inflation

In reality, policymakers are indeed uncertain about how quickly inflation will cool down and whether the recent string of better-than-expected data will be fleeting, just like in 2021.

Richmond Fed President Barkin warned on Wednesday that if inflation appears to "flare up again, we would like to keep the option open to take more measures on interest rates." Federal Reserve Chairman Powell also seemed cautious earlier this month about the risk of being "misled" again by good news on the inflation front and left the door open for further tightening of policy.

Charles Evans, the former Chicago Fed Chairman who retired in January this year, said, "If you hear the Fed Chairman or others say 'rate hikes are over' soon, I would be very surprised." John Roberts, who worked at the Federal Reserve for 35 years and left in 2021, added, "This is definitely not the time to celebrate victory."

Nevertheless, officials cannot deny that data is beginning to suggest that they may have taken sufficient measures to squeeze the economy. With the slowdown in business activity in manufacturing and services, consumer spending has already begun to cool. Demand for workers has also decreased, but the labor market has not yet seen serious cracks. Perhaps the most encouraging signal comes from the October CPI report, which shows that the annual inflation rate has slowed to 3.2%, a drop greater than the market consensus.

For officials to consider rate cuts, they need to be convinced that inflation is falling back to 2% in a sustainable manner. Powell stated earlier this month that officials are "not at all" considering such policy actions.

However, Powell has previously provided insights into the Federal Reserve's views on rate cuts. In September, he hinted that rate cuts might be justified as inflation slows, to prevent the Federal Reserve's policy rate levels from becoming overly restrictive. This adjustment could be similar to the three rate cuts the Federal Reserve began in July 2019 – which the Federal Reserve referred to as "insurance rate cuts" – aimed at mitigating economic risks.How might the Federal Reserve consider lowering interest rates?

The Federal Reserve may need to see several more reports reflecting a downward trend in inflation, similar to the October CPI report.

Roberts, currently a senior advisor at Evercore ISI, pointed out that the core PCE inflation annualized rate has dropped to 2.5% over the past six months, close to the 2% target level. He said: "It is not inconceivable that inflation could fall to a level where the Federal Reserve is willing to lower interest rates by the middle of next year." Data released on Thursday showed that the annual growth rate of core PCE in October was 3.5%, with a month-on-month increase of 0.2%.

If economic activity suddenly plummets, this could also affect the Federal Reserve's interest rate path, but staff and officials do not anticipate this. According to the latest economic forecast released in September, policymakers expect only a 0.5 percentage point reduction in interest rates next year, with core inflation falling to 2.6%, growth slowing to 1.5%, and the unemployment rate slightly higher at 4.1%. These forecasts will be updated next month.

Deutsche Bank economists currently predict that as the economy falls into a "mild" recession in the first half of 2024, the Federal Reserve will begin to lower policy interest rates in June next year, with a total expected reduction of 1.75 percentage points by the end of the year. UBS also expects the US economic growth rate to stagnate at around 0.3% next year and expects interest rate cuts to begin in March.

Evans said: "Now that inflation has fallen, if the economy weakens, they do have the ability to adjust the funds rate lower, but it will still be restrictive. This will give them more policy options to prevent the inflation rate from remaining close to 4%, not to mention that they are currently uncertain whether the inflation rate will fall."