FOMC Preview: The Case for Policy Nimbleness

Summary

• The Fed is planning unprecedented easing during an expansion.
• Meanwhile, the FOMC will likely heed Waller’s call for policy nimbleness due to multiple uncertainties including:
  • The shape of the Beveridge curve.
  • The inflation impact of lower immigration.
  • The elections outcome and associated economic policies.

Market Implications

• I expect a 25bp cut this month and a total of three in 2024, against the market pricing 1.3 and 4.6 cuts, respectively.

Ambitious Easing Plans

In my Fed Monitor yesterday, I took stock of recent economic developments and Fed communications. I concluded a 25bp cut was likely next week and that the SEP was likely to show three 2024 cuts, which is also my Fed base case. Here, I look in-depth at the economic uncertainty and policy dilemmas the Fed faces.

The Fed is gearing up for cuts of up to 225bp (June SEP) even though the economy is not in recession and the Fed has a positive economic outlook. This would be unprecedented (Chart 1), which I think reflects three key factors.

First, progress on disinflation, especially wages. At 3.8% YoY, the latest wage print is close to what the Fed considers consistent with 2% inflation, or 3.5% based on 1.5% productivity growth.

Second, monetary policy is tight. If policy restrictiveness is measured by the difference between the actual FFR and the Taylor rule, policy is tighter than under the Bernanke (2006-14), Greenspan (1987-2006) or even Volcker (1979-87) Feds at comparable levels of inflation (Chart 2).

Third, signs suggest Fed tightening has weakened the economy’s capacity to absorb shocks. For instance, shocks such as extreme weather events have started hitting employment. SME and lower income household balance sheets have weakened. Also, the stay on reporting of student loans delinquencies to credit agencies is about to expire, which could tighten household credit conditions.

Against the Fed’s ambitious easing cycle plans, Governor Waller has strongly advocated for policy nimbleness in a recent speech. I think this reflects unusual economic uncertainty.

Traditional Economic Relationships Have Broken Down

Waller stated in his speech, ‘reliance on old lessons from inverted yield curves to predict a recession, a Phillips curve to predict inflation, or a flat Beveridge curve to predict the movement in the unemployment rate have all led to mistaken economic forecasts.’

The Beveridge curve (the relation between unemployment and vacancies) is a case in point.  In 2022, Waller argued a soft landing was feasible if the job market rebalanced through a decrease in unusually high vacancies rather than through an increase in unemployment.  Waller was correct. The vacancy rate fell and wage growth slowed with only a limited increase in unemployment (Chart 3).

In other words, the labour market moved along the steep part of the Beveridge curve, where a large decrease in vacancies comes with only a small increase in unemployment (Chart 4).

This July, Waller flagged the risk that if the vacancy rate fell below pre-pandemic levels, the economy could end up in the flat part of the Beveridge curve, where a small decrease in vacancies is associated with a large increase in unemployment. Preventing this could justify substantial policy easing.

Also, recent data suggests supply conditions could be about to become less favourable.

Tighter Border Controls Could Slow Disinflation

In his Jackson Hole speech, Fed Chair Jerome Powell stressed the positive role played by immigration in raising labour supply and contributing to the soft landing. Because the Bureau of Labor Statistics’ household survey undercounts immigration, Fed staff have built their own estimate of the labour force.

However, since June, the Biden administration has tightened border controls and border apprehensions have fallen, suggesting fewer migrants. As a result, risk exists the combination of high NFP, rising unemployment and weak wage growth that prevailed over the past year could reverse. The August employment report showed lower NFP, lower unemployment and faster wage growth.

Because there is no reliable data on the recent immigration surge, it is difficult to assess its macro impact. However, we may be about to get a real life counterfactual and its potential impact on wages is cause for policy caution.

Lastly, political uncertainties compound these economic uncertainties.

Election Outcome Matters for Economic Outlook

As previously discussed, presidential candidate Donald Trump’s economic policies could cause major economic instability. Fed independence could also come under pressure.  During Powell’s July testimony to Congress, a few Congress members advised him that easing before the election risks being perceived as partisan.

Currently, the race remains tight, another reason for policy to be nimble and for the bulk of the Fed 2024 easing to happen after the 5 November election (the Fed meets on 6-7 November).

Market Consequences

I expect a 25bp cut this month and a total of three in 2024, against the market pricing 1.3 and 4.6 cuts, respectively.

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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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(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.)