Monetary Policy & Inflation | US
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Summary
- Growth and inflation have been surprising on the downside, though economic fundamentals remain strong.
- The Fed sees balanced risk to the employment and inflation legs of its mandate and could cut once in 2024 to lower downside risks to growth.
- The cut would most likely happen at the November or December FOMC as the political gains of cutting later outweigh the economic costs.
Market Implications
- I now expect the Fed to cut once in 2024, likely in November or December, against the market expectations of 2.7 cuts by December and 3.4 by January 2025.
- We like to trade this view as a tactical short in the Jan Fed Funds.
Slower Growth and Inflation
As discussed in recent research, inflation and growth have slowed. I expect the growth soft patch to self-correct as it reflects mainly the normalization of personal income tax payments that should run its course by Q3. Also, the consumption growth slowdown is limited, and corporate investment is booming (Charts 8 and 11).
I was more surprised by the resumption of disinflation, which seems to reflect a small cycle in consumer energy prices (Chart 3). June core PCE is likely to be 2.6% YoY, the same as May and in line with the SEP’s 2.8% Q4/Q4. Considering Viresh’s view that crude prices could be rangebound until end-year, I see limited further downside to core PCE.
Also, while shelter disinflation finally resumed in June, the fundamentals of the housing market remain strong. Market rents inflation has rebounded, and vacancies remain below pre-pandemic levels (Chart 4).
Fed Sees Balanced Risks to Inflation and Employment
In a recent testimony and Q&A, Fed Chair Jerome Powell acknowledged these changes. In a 15 July Q&A he stated the last three inflation prints ‘did add to Fed confidence.’ He also stated he would not indicate timing for the start of easing. As always, decisions will be made ‘meeting by meeting, based on the totality of the data and its implications for the outlook and the balance of risks.’
On the other hand, Powell expounded the Fed’s reaction function. He stated the risks of the inflation and employment legs of the mandate were now balanced so that, if the labour market showed unexpected weakness, the Fed would react quickly (Charts 5 and 9).
By ‘unexpected’, I think Powell means weaknesses above and beyond labour market rebalancing. For instance, NFP falling below pre-pandemic averages of about 170,000, unemployment rising above 4.5%, or a sharp increase in unemployment relative to vacancies.
Also, Powell made clear he maintained a positive economic outlook, ‘Recent indicators suggest that the U.S. economy continues to expand at a solid pace.’ He still expects a soft landing, largely because labour market overheating reflected the pandemic rather than excess demand.
Long term, Powell did not expect the policy rate to go back to the pre-pandemic lows.
Insurance Cuts at the November or December FOMC
I think these data suggest a 2024 insurance cut meant to limit downside risks to growth and provide relief to lower income families (a concern of many participants to the June FOMC). In the June SEP, no participant saw growth risks tilted to the upside, and three saw them to the downside.
By contrast, only one June FOMC participant saw risks tilted to the downside for core PCE, and 11 tilted to the upside. It therefore seems reasonable to assume the May and June inflation prints surprised FOMC participants.
Also, the fundamentals have not changed so much that inflation is clearly decreasing. The regional Feds have recently published a string of research notes highlighting upside inflation risks. Upside risks to shelter inflation remain substantial – the labour market, as Powell stated, remains strong, and the capex boom suggests business are still in expansion mode. Furthermore, Powell sees the policy stance as restrictive but not ‘severely’ so.
I expect the cut to happen at the 7 November or 18 December FOMC, rather than at the September FOMC, provided the labour market shows no unexpected weakening. Since the economy strong, cutting in November or December would make little difference to the economic outlook.
On the other hand, cutting after the election would give the Fed more visibility on the economic program and associated inflation risks of the incoming administration. Also, during last week’s testimony Powell was warned cutting before the election could cost him Republican support for Fed independence. Fed independence could be at risk from a Donald Trump administration, especially as Republicans appear likely to win the White House and both Houses of Congress. I think the political benefits of waiting exceed the economic costs.
Market Consequences
I expect one cut at the November or December FOMC against the market pricing 2.7 cuts by December. We like to trade this view as a tactical short in the Jan Fed Funds.
Current Fed Macroeconomic Forecast
Recent FOMC Comments
Disinflation Is Still Stalled
Political and Economic Risks Are Rising
Fed Tightening Transmitting Poorly
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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
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