Commentary on Political Economy

Friday 5 April 2024


Today’s Points

It’s The Same Old Song

Jay Powell’s remarks at Stanford University Wednesday were a rehash of a very familiar chorus, but that didn’t stop everyone from hanging on his every word. The Federal Reserve is very much data-dependent, and rate cuts will happen when there’s enough confidence that inflation is well within control. The last mistake Chair Powell will want to make is to ease too soon, especially after all the work done to rein in inflation from decades high. It’s almost unthinkable what a premature rate cut that caused inflation to spiral again would have on the Fed’s credibility. 

Regardless, Powell’s umpteenth reassurance did not pass without a reaction after yet another switchback in the economic data. He talked after the market had heard that private-sector payrolls were growing more than expected (suggesting less need for rate cuts), and also less than two hours later that the ISM survey of supply managers in the services sector had found the most benign reading on prices in four years (suggesting rate cuts might go ahead):

This zigzag followed a welter of data that has doused the optimism for multiple rate cuts at the start of the year. Now, there is an increasing possibility of a no-landing scenario with higher-for-longer rates. While Powell’s stance had barely changed, it calmed the markets, as it has time and again in the last six months. The absence of any newly hawkish sentiment was enough to drive a turnaround in the bond market:

When the 10-year yield briefly topped 4.42%, that was the highest since November, before Powell signaled a dovish “pivot” toward rate cuts at the December meeting of the Federal Open Markets Committee. It prompted some alarm, but by the close, the yield was back where it started, within its recent ranges, and the stock market registered a small rise.   

The real fed funds rate, defined as the fed funds rate less the PCE deflator measure of inflation, stands at 2.9%, the highest in nearly 17 years. Normally, that should be concerning. But there are mitigating factors, driven by the very market optimism that has created an easing of financial conditions by the Fed’s own measure to a level not seen since January 2022, when rates were effectively at zero and there was still a passionate debate over whether inflation was transitory:

Somehow, the Fed’s most aggressive hiking cycle in decades has left us where we started — which doesn’t make much sense. Is this sustainable? SMC Nikko Securities’ Joseph Lavorgna argues not for long, unless the Fed does indeed cut rates:

Historically, when real rates are high for long enough, growth eventually slows. At this point, they want to avoid a more significant slowing in the economy, especially given that the labor market imbalances aren’t as pronounced. In other words, we have the unemployment rate and job openings becoming more in alignment with what the Fed believes is a non-inflationary situation… New rate cuts are still the most likely scenario when they come and how many we get will be based on how the economy performs.

When the first rate cut will happen remains wide open. Bloomberg’s World Interest Rate Probability, derived from fed funds futures, suggests that the market is now pricing in about a 60% chance of a June move, up from 50% before Powell’s appearance, but there’s still no conviction. The indecision also stretches to the quantum of cuts expected, which is probably more important than the timing of the first one. The generous 170 basis points of cuts priced in at the beginning of the year have now come down to 70 bps, and as NatWest Markets shows in this chart, that is the first time investors have expected less easing than the consensus of the Fed’s predictions for the end of the year in its quarterly “dot plot” since 2022, which was during the hiking cycle:

Friday’s March employment data provides the next big metric for the Fed. TS Lombard’s Steven Blitz is unsure what lies ahead, but by using a three-month rolling average of inflation shows that the trend is rising again: 

The math in my adjusted Taylor Rule (a guideline central banks use to control interest rates to stabilize the economy) illustrates the dilemma. If month-on-month Core PCE inflation averages 4.0% (average of the past three months is 3.5%) between now and June, the year-on-year pace is still sitting at 3.0%, leaving room for a rate cut or two – but the year-on-year would be 4% by year-end, and that says a 6.0% funds rate. Absent faltering real growth, a June cut adds to price momentum narrowing the real funds rate and gives growth a boost. 

One word that characterizes all that the Fed is seeking to do is balance. Powell concedes that the priority is getting the timing right — if it must cut at all. Leaving it too late would come with its own consequences, which might dent the institution’s policy credibility. But for now, everything is made easier by the way the market thinks it’s at last on exactly the same page as the central bank. 

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