Change of Call: 50bp Fed Cut in March

Summary

• Historically, core PCE has (almost) never been at 2.4% as the Fed expects in 2024; it has been either below 2% or much higher, which is consistent with a ‘regime’ view of inflation.
• The SEP inflation scenario, if it materializes, is therefore likely to become a return to the pre-pandemic chronically underperforming inflation.
• A return to ‘lowflation’ would see many more 2024 cuts than the 75bp in the SEP as the Fed’s resolve to fight it is likely as strong as before the pandemic.
• The first cut is probably in March because:
  • Likely low core PCE prints up to the March FOMC meeting will add to the risks of lowflation.
  • The Fed would rather be proactive in its fight against lowflation.
  • The Fed would rather cut well before the election season intensifies, which suggests cutting before H2.
• On balance, I see a March 50bp cut as more likely than not. This because the Fed looks at policy in a probabilistic manner, weighing the risk of being too tight versus too loose.

Market Implications

• Against my expectations of a 50bp cut, the market sees only a two-third chance of a 25bp cut in March.

SEP: Either Inflation or the FFR Is Too Low

The SEP expects 2024 core PCE to fall to 2.4% Q4/Q4, which would come with three 25bp rate cuts. (As always, this discussion is about what the Fed is likely to do, not what I think it should do.)

In reality, core PCE has (almost) never been at 2.4% (Chart 1: orange line = actual core PCE YoY, blue line = SEP, dotted line = 2.4% level). It has tended to be either below 2% or much higher, for example during the 1970s and pandemic. This pattern is consistent with the BIS view that inflation tends to remain in either high or low regimes with very different dynamics.

So if the good disinflation scenario shown in the SEP materializes, rather than a well behaved inflation asymptotically converging to 2% over 2024-26, inflation is likely to undershoot the Fed target.

For instance, if we assume that average 2024 monthly core PCE is 12bp, the 2019 average, Q4/Q4 core PCE would be 1.5%. Twelve bp is not unrealistic as average monthly core PCE was 18bp for the past three months and 15bp for the past six months.

In such an instance, the Fed would cut a lot more than the 75bps pencilled in the SEP!

Fed to Fight Return to ‘Lowflation’

The Fed shows no sign of having given up the fight against ‘lowflation’. In 2020, this fight led the Fed to adopt an average inflation targeting (AIT) framework. In 2019, the Fed cut, even though unemployment was below 4% and falling. For the preceding two decades, the Fed kept rock-bottom policy rates to try to get inflation nearer 2%, with limited success (Chart 2: orange line = FFR-core PCE, blue line = core PCE YoY, dotted line = 2%).

The pandemic inflation spike has likely not changed the Fed view on inflation trends much.  This is visible in the SEP, where the long-term FFR has been 2.5% since June 2019 (Chart 3: orange line = long-term dot, blue line = 3-year-ahead dot, grey line = spread).  That is, the Fed does not anticipate its policy rate needing to be permanently higher to keep inflation at the 2% target.

At the same time, the Fed seems not to have totally ruled out the risks of a higher long-term FFR. This is visible in the spread between the long-term dot and the three-year-ahead dot.  Even though the Fed expects inflation to be back at the 2% target by 2026, it still sees the end-2026 FFR above its long-term value. The spread between long-term and three-year-ahead FFR has only been higher once, in June 2019, before the Fed decided to cut and lower the dots.

The Advantages of Frontloading

There are three broad reasons why the Fed is likely to frontload its 2024 cuts.

First, the risks of a return to lowflation are rising, as shown by the six-month core PCE that is already below the Fed target and likely to fall further (Chart 4: orange line = 6m saar, dotted line = 2%). Core PCE is the Fed’s preferred measure of inflation and the key indicator for the Powell Fed. In the December minutes, participants noted ‘the recent shift down in six-month inflation readings’.

Core PCE readings up to the March FOMC (December and January) are likely to remain low.  The consensus estimate for December core CPI is 0.2%, and historically core PCE has been on average 4bp below the CPI. Furthermore, January gas prices, a good real-time proxy for the energy CPI, are likely to be below December. Due to the correlation between energy and core inflation, this suggests another low inflation print in January.

Second, the Fed will want to be proactive in its fight against lowflation.

The third reason for frontloading is the electoral calendar. It could impact the Fed’s timing in two ways. On one hand, the elections (scheduled on 5 November) will be among the most contentious since WWII. The Fed could therefore prefer to cut well beforehand to avoid accusations of bias.

On the other hand, some have argued that the Fed pivot is meant to boost President Biden’s re-election prospects. This is another reason to cut early: to let the cuts work their way through the economy and asset markets.

By the 26 July FOMC meeting, the campaign will be in full swing: the Republican and Democratic conventions are in mid-July and mid-August, respectively. Since a January cut is unlikely, the electoral calendar in effect leaves the Fed with only three meetings when they can cut.

50bp Cut in March

Following the December FOMC, I built Fed scenarios based on PCE prints. In the good scenario, i.e., the SEP, I anticipated 200bp of cuts in 2024. This would leave the end-2024 FFR at 3.33%, against the 2026 SEP FFR at 2.9% and the long-term FFR at 2.5%. But if the good inflation scenario becomes a return to lowflation, my forecast is, if anything, too conservative.

Of course, by the March meeting, the Fed will not know with certainty if the good scenario will materialize. Rather, it is likely to think about policy in a probabilistic manner: it will weigh the risks of being too tight versus too loose.

That is why, on balance, I see a 50bp cut at the March FOMC meeting as more likely than not (my probabilities are 50% for 50bp, 40% for 25 bp, and 5% for no cut).

Market Consequences

Markets are currently pricing only about a two-thirds chance of a cut by March, against my expectations of one 50bp cut.

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.

(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.)