Key Highlights

• A quarter-point cut is almost guaranteed on Wednesday
• Forward guidance for December and beyond is likely to be limited owing to a lack of data and considerable uncertainty about the outlook
• QT will likely also be suspended, given tightness and volatility in funding markets as reserves continue to decline

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A 25bp cut on Wednesday with limited forward guidance

EXHIBIT #1:  DOVISH RATE EXPECTATIONS INTO 2026

_{Source: BNY Markets, Bloomberg}

The October FOMC meeting this Wednesday is almost certain to result in a 25bp reduction in the federal funds rate, and we think – as we have since late summer – that the Fed will also announce an end to quantitative tightening (QT). We expect very little, however, in the form of clear forward guidance for the December meeting and into 2026, given the continued lack of government data due to the shutdown, and the unlikely prospect it will be resolved any time soon. We don’t rule out the possibility of a dissent in favor of two cuts, or the possibility of a dissent in the other direction in favor of no move at this meeting.

The rates view is fully priced into the market, which assigns a 100% probability of a cut this week. A December cut is expected with almost the same degree of conviction as the October move, and the curve exhibits a dovish tone out to the end of next year, as shown in Exhibit #1. We’re much less convicted on our 2026 view, and here again, the ongoing absence of data makes it hard to assess where the economy is, as well as where it’s going.

EXHIBIT #2:  INFLATION EXPECTATIONS – ANCHORED OR NOT?

_{Source: BNY Markets, Bloomberg, Federal Reserve Bank of New York}

We wouldn’t call last week’s September CPI (published as a special “one-off” report amid the ongoing government shutdown) a benign one, even though it missed consensus by a bit to the downside. More relevant – and a little concerning – to us are still-elevated short-term inflation expectations as shown in Exhibit #2. We display the 1y inflation swap and 1y expectations from the New York Fed’s Survey of Consumer Expectations, both of which continue to inch up (although the 1y inflation swap has come down from 3.2% at the end of September to 3.0% currently). We also show, in orange, the 5y5y inflation swap rate, which has been steady at around 2.5%.

Given that these longer-term inflation expectations remain anchored, the Fed will justify cutting rates even though the September CPI rose to 3.0% y/y (both headline and core), a third straight acceleration and the fourth in the last five months. We know that the Fed’s working hypothesis is that tariff-induced price rises will be – in Chair Powell’s words – “one time, but not all at once,” and not the beginning of an inflationary process. However, we are still wary of price pressures in the economy and those stubborn short-term inflation expectations, which could – especially in a world of expansionary fiscal policy and falling policy rates – still spill over into actual price developments. Therefore, we expect that the Chair will be cautious and noncommittal about the future policy path given inflation’s persistence.

So why then is the Fed cutting? It’s clear – despite a lack of official data – that the employment picture is troubling, with a lack of hiring even though layoffs – as far as we can measure – are not showing signs of picking up. Last month’s rate cut was characterized as a “risk management” move by Powell, given that “the labor market is really cooling off.” Indeed, and perhaps ironically, we think the lack of data over the past month would embolden the Fed to cut again, considering that the same risks are likely present.

The end of quantitative tightening is nigh

We had been expecting the Fed to cease its balance sheet runoff at this meeting, and the market seems to have come around to this view as well. We’ve commented recently that bank reserves are close to having transitioned from an abundant state to a merely ample one (see here and here, for example). Abundant reserves describe a regime in which liquidity is such that changes in reserve levels do not lead to changes in the effective federal funds rate. An ample reserves regime describes a situation in which the front-end interest rate complex is indeed responsive to movements in reserves. We think we’re quite close to that situation now.

EXHIBIT #3: SFR USAGE INCREASINGLY FREQUENT

_{Source: BNY Markets, Federal Reserve Bank of New York}

We note that with reserves at or below $3tn since mid-September, we have seen the effective federal funds rate (EFFR) rise from 4.08% immediately after the September 17 FOMC (which featured a 25bp reduction in the target rate) to 4.11% since then, along with elevated and volatile funding rates. Counterparty usage of the standing repo facility (SFR) has increased in frequency, no longer occurring only at quarter-end or on specific payment dates. Exhibit #3 shows this more frequent usage of SFR. In fact, on Monday this week, it was tapped for $8.5bn, the largest quantity since the second quarter ended on June 30, when there was over $11bn in usage. This pattern strongly implies the decline in bank reserves is indeed beginning to bite. 

EXHIBIT #4: RESERVES RELATIVE TO SIZE OF ECONOMY AND BANKING SECTOR KEEP DECLINING

_{Source: BNY Markets, Bureau of Economic Analysis, Federal Reserve Board of Governors}

It's also interesting that in his last public appearance before this month’s blackout period, Chair Powell delivered a speech on Fed balance sheet developments, a subject he doesn’t often address explicitly or in depth. He conceded that “some signs have begun to emerge that liquidity conditions are gradually tightening, including a general firming of repo rates along with more noticeable but temporary pressures on selected dates,” and that the Fed may approach the transition from abundant to ample reserves “in coming months.” These remarks were delivered two weeks ago, and since then conditions have only tightened. 

Along with the expected cessation of QT, we expect the Fed to announce it will be reinvesting its proceeds from maturing UST and MBS securities back into shorter-dated treasuries, an attempt to guide the Fed’s portfolio, known as the System Open Market Account (SOMA) closer to one that resembles the maturity composition of Treasury securities outstanding. For example, while SOMA is about $6.5tn in size, only around $200bn are in T-bills (approximately 3%), while the T-bills in circulation comprise 17% of all debt outstanding. The Fed’s ambition to achieve a SOMA portfolio with a maturity distribution resembling public debt outstanding is to us, aspirational, and not something that could be achieved in a short period of time.

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