Monetary Policy & Inflation | US
The recent drop in inflation is real and the rising risks of some more weakness in labour demand increase the odds that the Federal Reserve (Fed) could cut rates by Q1 as a recalibration of policy, in particular after the recent speech by Christopher J. Waller, who clearly hinted to surgical cuts to the policy rate in response to falling inflation in order to prevent unnecessary tightening due to elevated real rates. Powell has repeated many times his objective to achieve a soft-landing and while a historically rare event, it has been achieved by the Fed back in the mid-90s with a series of surgical cuts after 300bps of hikes. If he manages to do that, after the great inflation spike post-Covid, he will go down in history as someone who managed to bring inflation back to target and at the same time avoided a recession, so better than both Volcker and Burns together.
We think that a major surprise in 2024 could be that even after possible cuts by Q1, or at least after the market pricing more than 4/5 cuts in 2024, the massive loosening of financial conditions we have been seeing since the beginning of November, with huge rallies in pretty much all assets, will push inflation to remain above the Fed target for longer and will sustain growth above potential, forcing the Fed to stay at least on hold. We do not exclude in this case that the Fed will have to tighten policy even more than it has so far. In this case, the markets are likely to reverse abruptly the current aggressive cuts priced in. We respect and understand Waller’s application of a simplicist Taylor’s rule, in particular given the recent drop in inflation, but we do not agree it is the right way to measure how much policy is restrictive: upside risks to the economy in H1 will be a major surprise.
Analysis
On the inflation side of the Fed’s dual mandate, recently inflation has dropped substantially and is already tracking below the Fed’s projections in the latest Summary of Economic Projections (SEP). Indeed, looking at the last three months annualized core PCE, we see a running rate of just 2.4%, not to mention that the last print annualized was exactly at target and six months annualized core PCE is growing at just 2.5% (Chart 1).
This means that at the next FOMC meeting the Fed will have to reduce their core PCE projection for 2023, which is currently 3.7% (percent changes from the 4th quarter of 2022 to the 4th quarter of 2023, Table 1). Indeed, for the current Fed forecast to materialize, we should have two core PCE prints of 0.5% MoM in November and December, which is very unlikely to happen.
Moreover, at this point a few other factors seem to be in play to achieve even further disinflation in the short-term.
First, a lot of the recent optimism on the down trend of inflation has been driven by the steep decrease in core goods prices, and with respect to this point, the normalization of supply chains is still ongoing as shown by the Global Supply Chain Pressure Index (GSCPI) computed by the Federal Reserve Bank of New York (Chart 2): indeed, the GSCPI dropped to -1.74 in October, down from -0.70 in September (revised down from an initial reading of -0.69). GSCPI readings measure standard deviations from the index’s historical average, and they clearly show that the easing process which started on December 2021 is still ongoing. The bottom line is that disinflation and actually a mild deflation in non-vehicle core goods prices has become an established trend which is lasting for a while.
Second, new vehicle prices have pretty much returned in line with their pre-Covid MoM average prints and used car prices have increased a little bit more but they should weaken again looking at the Manheim Used Cars Index, which tends to lead quite well US CPI Used Cars & Trucks Index (Chart 3).
Third, housing inflation keeps moderating even if at a slower pace than previously expected (Chart 4). On a 3m annualized basis, Owners’ Equivalent Rent inflation has recently paused the downtrend and started to pick up but continues to trend down on a YoY basis (Chart 5). On a 3m annualized basis, Rent of Primary Residence is also showing some stickiness, but the down trend continues to be in place in particular on a YoY basis, but somehow less so on a 6m annualized basis (Chart 6). As it is well known housing inflation lags all sorts of different measures of market rent inflation for obvious reasons, but taken all together, they tend to suggest that some more housing disinflation should be in the cards (Chart 7 shows the case using, for example, the Zillow Rent Index).
Fourth, in terms of the stickiest part of inflation and the one that is related the most to wage growth and the tightness of the labour market – core services excluding housing – we also had a downward trend in particular looking at PCE, whereas in CPI terms there has been more a sideways move and the last print for November was still a solid 0.44% MoM. Moreover, wage growth is weakening as predicted by quits (Charts 8 and 9), which again suggests that in the short-term we should see more disinflation in the pipeline also on this front.
On the labour market side of the Fed’s dual mandate, while layoffs remain low, labour demand has started to show some signs of weakness (Chart 10). Indeed, the anecdotal evidence from quarterly earnings reports, from the Beige Book, and from various surveys seem to suggest we will see some more upward pressures on claims beyond the recent increase, probably more due to issues related to seasonal adjustments. Many leading indicators have suggested a more material pick up in claims for many months and they have been wrong so far. Nevertheless, as mentioned above, anecdotal evidence is building up suggesting that some more weakness (from extraordinarily strong and tight levels) will materialize in the next few months: the unemployment rate has risen to 3.9% above the 3.8% level projected by the FOMC for the end of 2023 (Table 1), but it has come down again to 3.7% in the last jobs report; the diffusion index, so how broad-based jobs gains are, began to decline and permanent job losses started to rise. Not only that, but the Conference Board survey also shows that consumers are seeing somehow more subdued hiring conditions. Lastly, the labour differential (the share of respondents saying that jobs are plentiful minus those saying that jobs are hard to get) recently has stabilized but it had a large drop since the peak at the beginning of 2022 and lies now slightly below the levels we had in the couple of years pre-Covid (Chart 10).
So far, it is not clear if we are seeing just a normalization of the labour market from very high and tight levels with the help of a recovery in labour supply, due to the surge in immigration and the rebounding in participation, or we are seeing the beginning of a recessionary dynamic. The last jobs report suggests the former, but we do not want to draw conclusions on just one report.
If there is one member of the FOMC committee who has got so far – and I stress so far – the immaculate disinflation right, this one is Christopher J. Waller, who has also a solid scientific credibility and reputation within the FOMC. Indeed, as we discussed above, the recent pace of core PCE has been close to 2% and the unemployment rate is currently close to its longer run level (4%) as per the latest SEP (Table 1). So, depending on where the neutral rate is, the market is not wrong to price quite aggressive cuts in 2024 (even without a deep recession) assuming core PCE will remain close to 2% in 2024 and we get more weakness in the labour market.
On top of that, recently Fed Chair Jerome Powell could have been more hawkish if he wanted, but he was not. If he had wanted to sound really hawkish, he would have not said: ‘the strong actions we have taken have moved our policy rate well into restrictive territory.’
It is probably not fully correct to set monetary policy purely based on a Taylor type of rule, as Waller has been hinting, but that does not matter, it matters what the Fed does. Personally, I agree with what Williams said recently: ‘the key for policy is the persistence of easing in financial conditions (FCs).’ So, assets prices.
And I think here is the key to a big surprise that could materialize next year.
If FCs keep loosening, we will probably not see high frequency core inflation to annualize close to 2% for the whole of 2024 (after passing the current favorable disinflationary impulse and the disinflation that is already in the pipeline as we saw above), and we will see a reacceleration of inflation with a run rate annualized of at least 3%-ish and with growth likely above potential. Not to mention that we have another QRA coming in Q1, and chances are that the coupon issuance could increase materially this time, similar to what happened back in August.
This outcome is completely not priced by the rates market, which is pricing the exact opposite.
Beyond all the good news we described above on inflation, there are some signs which suggest a little more prudence on the narrative that (core) inflation is going sustainably to 2% for the whole of 2024 and beyond, in particular in an environment where the FCs could keep loosening.
On the core goods side, as highlighted on 4 December by our friend Phil Suttle[1] – ‘the Baltic Dry freight rate is up 3-fold since early September, to its highest since the logistics shortages of 22Q2 (Chart 11). It is up 52% in the past week alone. Drought-related restrictions on Panama Canal traffic may be playing some role, with Capesize ship rates (the largest that are too big to go through the Panama Canal) up the most. I do not have good visibility on what is driving the most recent BDIY surge but would note that much of the recent optimism on global inflation has been driven by tumbling core goods prices. BDIY up over 50% in the past week is hardly congruent with that development (and could cause the NY Fed supply chain index to jump this December).’ Since then, the index has retraced a little bit but remains elevated.
In relation to housing inflation, I showed that the downtrend looks well-established, but as today’s CPI report shows, risks are still two sided and there can always be some shifts in trends (Charts 5 and 6). For example, as recently written by Julia Coronado and Laura Rosner-Warburton of Macropolicy Perspectives[2] [3] – who correctly predicted the current downtrend in housing inflation – ‘there is still some uncertainty over the timing of the next leg down. The upside risk scenario involves less pass through of the moderation in market rent measures into CPI due to sampling or other methodological differences. The slight pickup in 3m rent momentum is notable (Charts 5 and 6). Regionally we have seen 3m momentum in rent inflation pick up in the Northeast and Midwest and within those regions the resilience looks fairly broad-based (Chart 12).’ They also note that the new tenant rent – which will be updated quarterly by the BLS – surged 4.4% QoQ (SA) in Q2 (second largest in history) and then rose a little more in Q3 (0.31%). To be noted that this latest data point could be subject to large revisions and so could be just an isolated outlier that will be then revised down; and other measures of market rent are not subject to these same revisions and do not show a strong pickup in Q2 (Charts 13 and 14).
We also look at landlords’ median asking prices[4], which are increasing again and despite the fact they are not actual rent, in the context of a Fed that could be cutting rates or at least the market keeps pricing more, they represent upside risks for housing inflation in 2024. Finally, to be noted that recently we also had a pickup in households inflation expectations and business price plans are rising[5]. As we saw in Charts 8 and 9, wage growth came down, but from very elevated levels and it is still reasonably strong and probably above a level consistent with inflation sustainably at 2%.
Looking at the broad economy, so far, we have not seen any material demand destruction, which does not come as a huge surprise given the strong household balance sheets and, more importantly, the still strong labour market. The latest JOLTS report for the month of October showed a stabilization in hires and quits whereas layoffs remain very low. Until November, when the massive loosening of FCs had started, we saw the Fed hiking rates first, then the long end rates moving higher above 5% after the surprise of a larger-than-expected coupon issuance in the August QRA, and we started to see some multiples compression thanks to higher yields with equity starting to drop as a result. That process, which was clearly starting to have a material negative wealth/aggregate demand effect – with both stocks and bonds selling off – has been abruptly interrupted with the November QRA where we had a lower-than-expected increase in coupon issuance followed by very soft inflation prints. This has triggered a massive loosening of FCs with pretty much all asset markets posting huge rallies, reversing that negative wealth effect.[6]
If FCs remain loose and keep getting looser (see in particular the long end of the Treasury curve) – very possible in particular if the Fed had really started cutting in Q1 – we struggle to see the Fed’s monetary policy being restrictive just because actual inflation is dropping and the real Fed Funds rate is increasing. And in this case, we also struggle to see (core) inflation trending sustainably towards the Fed’s target, because demand would still remain too strong. We had a lot of disinflation related to supply bottlenecks, energy prices, housing etc, but without a restart of the process we described above (with long end yields going again significantly higher) followed by demand destruction, earnings contractions, further fall in equity and ultimately widespread job losses and a recession, we think the biggest surprise in 2024 could be a reacceleration of inflation and growth forcing the Fed to reverse its likely upcoming cuts and/or forcing the market to dramatically reverse its pricing in the STIR market [6]. Of course, everything could work in the Fed’s favour and we could reach a perfect soft landing with 2% inflation, Fed Funds rate cuts by 100/150bps and growth close to potential, but the longer the Fed does not respond to looser FCs, the larger becomes the risk that Powell could turn into the new Arthur Burns if the economy is not heading to a recession (a recession would likely drop inflation below target).
If this surprise (i.e. reacceleration scenario) materializes in 2024, the rates markets are completely mispriced. Instead, if the economy is heading to a recession the equity market is completely mispriced. Both markets are currently priced for a perfect soft landing.
Footnotes/References
[1] Phil Suttle, Daily Comment, 4 December 2023, Suttle Economics.
[2] Julia Coronado and Laura Rosner-Warburton, October CPI Review: A More Established Downtrend, 16 November 2023, Macropolicy Perspectives.
[3] Julia Coronado and Laura Rosner-Warburton, MPP Inflation Update: A New Rent Index, 30 November 2023, Macropolicy Perspectives.
Julia Coronado and Laura Rosner-Warburton, November Employment Preview: Hoarding Onto Growth, 4 December 2023, Macropolicy Perspectives.
[4] Mikael Sarwe on Twitter, https://twitter.com/MikaelSarwe/status/1730221095658156184/photo/1, 30 November 2023, Nordea.
[5] Mikael Sarwe on Twitter, https://twitter.com/MikaelSarwe/status/1730221095658156184/photo/1, 30 November 2023, Nordea.
[6] Andy Constan, Microsoft Word – The Script.docx (dampedspring.com), 10 July 2023, Damped Spring.
Antonio Del Favero is a macro strategist at Macro Hive, focusing mainly on US economy and markets and G5 FX. Formerly, he worked at Tudor and Maniyar Capital, Rubrics Asset Management, Brevan Howard, Credit Suisse and UBS. He holds a Master in Finance from the ETH/University of Zurich and a Master in Economics from Bocconi University.