Monetary Policy & Inflation | US
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Summary
- A surge in policy uncertainty is starting to undermine growth while inflation risks remain tilted to the upside.
- On the eve of the pre-meeting blackout, with the SPX already down 6%, Fed Chair Jerome Powell indicated a continuation of the Fed’s wait and see stance.
Market Implications
- I still expect no cuts in 2025 against markets pricing about 3.5 cuts because I am expecting the Trump administration to change its policies before their negative impact on growth become irreversible.
- I will change my Fed view if that does not happen within a few weeks.
Uncertainty Undermines Growth
Markets are pricing near zero percent chance of a cut next week and 3.5 cuts by yearend. I agree with the former but do not expect Powell to validate the latter.
What a difference three weeks make. In my Fed Monitor three weeks ago, I raised the risk that strong growth and inflation could lead the Fed ending its policy easing bias this year.
However, since then multiple policy gyrations have caused uncertainty to surge. In turn, this triggered a 10% (so far) SPX decline and negatively impacted consumer and business sentiment and spending. By contrast, inflation risks are roughly unchanged and remain tilted to the upside.
The surge in policy uncertainty has been greatest with trade policy but tax and regulation uncertainties have also increased (Chart 1). Because employment and business investment are negatively related to uncertainty, these will be impacted, unless the government changes its policies (Chart 2).
The negative impact of uncertainty on growth is already showing. The Atlanta Fed GDP nowcast for Q1 is -2.4%, which reflects an unprecedented increase in imports triggered by expectations of higher tariffs (Chart 3). But even the final domestic sales (GDP ex inventories and net exports) growth nowcast at 1% is well below actual growth of 3% in Q4.
The sales slowdown mainly reflects a contraction in consumer spending in January, following a sharp increase in the savings rate likely spurred by heightened uncertainty (Chart 4). By contrast, real household income growth remained robust.
It is not all bad news yet. The February labour market report was consistent with robust household income growth. The unemployment rate remained near historical lows and real wages growth continued increasing (Chart 7).
Capex so far does has not weakened, the Atlanta Fed nowcast sees it contributing 1/2ppt to Q1 QoQ SAAR growth but recent business surveys signal more cautious business spending ahead (Chart 8).
Inflation Risks Remain Tilted to Upside
Meanwhile, inflation dynamics have not improved. January core PCE slowed to 2.6% yoy from 2.9% in December, but this reflects largely a base effect (Chart 7). Also, February wage growth remained sticky (Chart 8).
Furthermore, survey-based inflation expectations have been rising though market-based expectations less so (Charts 9 and 10).
Lastly, the latest Fed Beige Book shows most businesses intend to pass on forthcoming tariff increases to customers.
Fed Still in Wait-and-See Mode
Powell’s speech on the eve of the pre-meeting blackout stated:
- The economy is strong though the latest data shows ‘a possible moderation in consumer spending’ and ‘heightened uncertainty about the economic outlook.’
- ‘The labor market is not a source of inflationary pressure.’
- ‘Inflation remains somewhat above target’ and ‘short term measures of inflation expectations have moved up.’ However, ‘most measures of longer-term expectations remain stable and consistent with our 2 percent inflation goal.’
He further indicated the Fed needs more clarity on administration policies in ‘trade, immigration, fiscal policy, and regulation. It is the net effect of these policy changes that will matter for the economy and for the path of monetary policy.’
His conclusion remains, ‘We do not need to be in a hurry, and are well positioned to wait for greater clarity.’
Powell gave his speech when the SPX was down about 6.5ppt from peak. As of this writing, the market is down 9.5ppt from peak but that is unlikely to have changed Powell’s views. As long as the sell off does not create risks to financial stability, Powell is likely to address it only to the extent that it impacts growth and inflation, which would require it to persist for longer than a few weeks.
FOMC members broadly agree with Powell’s views though on aggregate. Our Fed LLM Sentiment Index shows FOMC members turning more hawkish since the January FOMC meeting (Table 1 and Chart 11). Furthermore, my core PCE-based Taylor rule suggests the Fed has finished cutting (Chart 12).
If anything, the data on policy transmission does not show much need to cut. Financial conditions are roughly unchanged since the January FOMC meeting and somewhat support growth (Chart 13). The real long-term dot remains well below market R* (5y5y real rates, i.e., the FOMC could be underestimating R* and overestimating policy restrictiveness, an issue raised by several FOMC members).
This wait-and-see posture suggests:
- No change to the statement except in the first paragraph to note risks of slowing growth.
No change to the SEP, including the dots. Recent data has been roughly aligned with the SEP, including growth, which has moved nearer the SEP (Table 2). In addition, the high policy uncertainty suggests no change to the forecast including the dots, though risk exists of an increase in the long-term dot given the gap with the long-term market’s real rate.
- Presser: I expect Powell to stick to the party line:
- The economy is in good shape.
- Policy is well placed to respond to inflation or employment risks.
- Long-term inflation expectations are well anchored.
- More information is needed to assess the overall impact of administration policies on growth and inflation.
- The Fed targets the economy rather than financial markets and it is too soon to assess whether the equity selloff will last and impact the economy.
Finally, I expect quantitative tightening (QT) to continue as indicated by the NY Fed.
Market Consequences
I still expect no cuts in 2025 against market expectations of about 3.5 cuts. This is because I believe the administration’s policies are driving the market selloff and demand weaknesses, rather than underlying structural weaknesses.
The administration is implementing tariffs in an abrupt and unpredictable manner that maximises their negative impact on the US economy. So far, the damage is not irreversible. Confidence can be restored, and consumption, employment and investment plans can still return to their pre-inauguration trajectory.
But if the administration continues its current trajectory, demand weaknesses will become self-reinforcing, and negative feedback loops are likely between consumer and business spending. Eventually, the economy would move to a lower growth path.
Based on the administration changing its implementation strategy within the next few weeks, I am not changing my view on growth (above trend), inflation (sticky) and therefore on my Fed call.
If the administration persists with its destabilizing statements, I will lower my growth forecast and change my Fed call.