Fed Preview: On Hold Through 2024

Summary

• The Fed will stay on hold next week, a move largely reflecting faster disinflation than in the SEP.
• I am changing my 2024 Fed call to on-hold through yearend, from previously two hikes. This reflects my expectations of:
  • Continued above-trend growth and tight labour market.
  • Financial stability.
  • Strong growth in labour supply and stable energy prices that will mask the inflationary consequences of above-trend growth.
• Based on these assumptions, I expect core PCE to stabilize around 3%, which would prevent the Fed from cutting.
• A Goldilocks macro backdrop would still prevail as BEs continue to show the market has strong faith in the Fed’s ability and willingness to stabilize inflation.

Market Implications

• Markets are overestimating rate cuts.
• Goldilocks economy to support risk assets.

Fed on Hold in December

The Fed has already decided to stay on hold next week. I think it is mainly because disinflation has happened faster than expected. Extrapolating the last three months’ core PCE to November and December would bring Q4/Q4 2023 core PCE to 3.3% against 3.7% in the September SEP.

I expect the forward guidance to remain in line with Chair Powell’s 1 December speech. In that, the most important sentence was this:

‘It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.’

(For details on FOMC members views and the macro backdrop, please see my Fed Monitor.)

I expect the SEP to reflect this forward guidance. That is, no major change except for 2023 core PCE marked down to 3.3% and the FFR to 5.3%, and the 2024 FFR marked down to 4.8% (Table 1). These are reasons:

1. The September SEP is already describing the soft landing the Fed wants.
2. Were the FOMC to lower its end-2024 core PCE forecast, it would be setting itself up for a tougher disinflation test, and there is not enough data yet to be confident it would pass that test.
3. More 2024 cuts than the two shown in the September SEP would require more disinflation. Also, additional 2024 cuts would risk easing financial conditions further.

I am changing my Fed forecast to no cuts through 2024 from previously two hikes, based on a more benign inflation view.

Inflation to Drive 2024 Fed Policy

As in Q4 2023, I expect Fed policy next year to remain driven by inflation, rather than by financial instability or weaker growth.

I continue to expect growth above trend next year, based on:

• No fiscal consolidation: the recent improvement in the budget balance reflects mainly the cancellation of student loan forgiveness (that was recorded upfront on a PV basis rather than on an accrual basis), rather than a long-term trend.
• Monetary tightening not getting transmitted to the real economy: shown by the recovery in residential real estate or the strength of durable goods consumption.
• Strong consumer balance sheets.

I do not expect financial instability to become a binding constraint for 2024 Fed policy based on:

1. Comprehensive support to banks through the Bank Term Funding Facility, which is likely to get extended for another year and through an implicit guarantee of all banks’ deposits.
2. Strong corporate and household balance sheets.
3. Limited transmission of monetary tightening to asset markets, as shown by the recent easing of financial conditions.

2023 Q4/Q4 core PCE is likely to print around 3.3%, against my forecast of above 4% that I was expecting mid-year. The discrepancy reflects supply factors, which I expect to last through 2024, though in a diminished form.

Slower Wage Growth Than Expected

About two-thirds to three-quarters of core inflation indices are accounted for by services. Services inflation is turn is driven by wages (Chart 1). Wage growth this year slowed more than I expected, mainly reflecting two factors (Chart 2).

First, an increase in foreign labour supply weakened the impact of the recovery on unemployment (Chart 3). Relative to end-2019, the labour force (i.e., labour supply) has increased by 3mn, with 80% of the increase coming from foreign-born, rather than US-born workers. Faster growth in the labour force has expanded the economy’s supply potential and capped wage growth. In real terms, the Q3 2023 median real wage (ECI) was below its end-2019 level.

While Congress sets the broad parameters of immigration policy, in practice the executive has some discretion. For instance, in the last two years of the Trump administration, foreign workers numbers stopped increasing. The recent increase could reflect an attempt by the Biden administration to mitigate the positive demand shock caused by its fiscal policy with a positive supply shock. Consequently, it is therefore unlikely to change next year.

Second, relative to unemployment, wage growth has been unusually slow (Chart 4). This could reflect:

1. Inflation was unexpected and it takes time for nominal wages to adjust, especially since wage agreements are often multi-year.
2. Low union density that has been on a decades-long downtrend. Currently only about 6% of private sector workers are unionized, against about 30% in the 1960s.
3. Worker preferences. Workers could have traded more flexible work practices, e.g., WFH, against lower wages: a BIS study of European labour markets found some substitution. This could well apply to the US (I discuss the US labour market here).

These factors could weaken somewhat in 2024 as more wage agreements reflect the higher cost of living. In addition, any trade-off between WFH and wage growth could be a one-off.

Overall, therefore, median wage growth could stabilize around 5%, compared with about 3.5% before the pandemic.

Energy Prices Drag Down Core Inflation

The other factor that falsified my inflation forecast was the decline in energy prices. The correlation between energy and core inflation has made a comeback (Chart 5), largely because the pandemic and associated policy responses have moved the US economy from a low to high inflation regime.

In a high inflation equilibrium, economic agents are highly attuned to signs of inflation such as higher energy prices and adapt their behaviour accordingly. As a result, oil price shocks transmit fast to the whole price structure.

In a low inflation equilibrium, by contrast, agents practice rational inattention – they tend to ignore oil price shocks because they expect inflation to remain low. As a result, inflation is self-stabilizing.

Chart 6 shows the impact of regime change, with a strong correlation between core and energy CPI during the 1970s and ’80s, a period of high inflation. The correlation disappeared afterwards as inflation fell to 2% or lower but made a comeback with the pandemic inflation surge.

In January, based on China coming back online around mid-year, I expected oil prices to rise and lift core inflation. In Q3, the view seemed to be working; oil prices rose and lifted core inflation (Chart 6).

But the oil rally did not last: prices fell in Q4 and brought inflation down.

For 2024, I will therefore assume oil prices will remain around their current level ($70/barrel). I expect this will come with a tight labour market, which would see core MoM inflation prints between 20bp and 30bp and end-2024 core PCE around 3% YoY.

With inflation above the SEP 2024 Q4/q4 forecast of 2.6%, the Fed would be unable to cut and would instead remain on hold through 2024.

2024 Inflation: Dormant but Undefeated

My 2023 inflation and Fed forecasts were falsified by supply factors. These were a labour supply increase and oil price decrease. That explains why my forecast was off on inflation but correct on growth acceleration.

My 2024 inflation and Fed forecasts are based on these supply factors turning less supportive of disinflation but not supportive of an inflation acceleration. I continue to expect above-trend growth (above 2%) and therefore a tight labour market (unemployment around 4%).

In this context, a resurgence of inflationary factors, for instance a pickup in oil prices, would get transmitted quickly to core inflation. In that sense, inflation is dormant rather than defeated.

Market Consequences

I expect the market to largely ignore Chair Powell’s guidance next week and no change to the five cuts currently priced in. For markets to move closer to the Fed SEP, several prints showing growth is not tanking and inflation is stable above 2.5% could be required. These will be available until Q1 of next year.

The Goldilocks macroeconomic scenario I expect for 2024 is also positive for risk assets.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)