Fed Review: Change of Call – No Cut in March

Summary

• The Federal Reserve (Fed) moved to an easing bias, but Fed Chair Jerome Powell ruled out a March increase, largely because he has less confidence about disinflation and is less concerned by inflation undershooting than I expected.
• A March cut could still happen if the economy weakened markedly or New York Community Bank’s difficulties become a full-fledged banking crisis, but neither appear likely.

Market Implications

• Markets still assign a 35% chance of a 25bp cut in March. My estimate is now nearer 10%.

Fed Moves to Easing Bias but Rules Out a March Cut

As I expected, the Fed moved to an easing bias. It removed references to policy firming from the statement and the presser preamble. The preamble stated, ‘we believe that our policy rate is likely at its peak for this tightening cycle’ and that ‘risks to achieving our employment inflation goals are coming into better balance.’

Contrary to my expectations, Powell ruled out a March cut, ‘March is not what we would call the base case.’

There were two key reasons. First, the FOMC was less confident than I expected on the inflation outlook. Powell was happy with the pace of disinflation but needed to see more data points, ‘it is not that we are looking for better data but rather a continuation of the good data.’

Specifically, Powell was concerned by:

• goods deflation may not last as ‘supply chains are not perfectly back to where they were.’ Over time, Powell expects goods deflation to reach zero, which would have to be offset by faster services disinflation (Chart 1).
• Uncertainty on timing and scope of housing disinflation. Powell was confident lower market rents would enter the price indices eventually but stressed the uncertainty around ‘when and how big it will be.’ He further mentioned ‘longer run problems with the availability of housing.’
• Powell ‘danced’ around the issue: wages were mentioned nine times during the presser, with Powell stating that easing wage growth that was ‘not quite where they would need to be in the longer run’ but never saying explicitly that he wanted slower wage growth in order to cut. I think Powell is concerned by the last two consecutive months of wage growth at 40bp but is reluctant to be too explicit because of political sensitivity.
• Data issues including this month’s CPI revisions.

(Chart 1: core PCE YoY: orange line = core PCE; blue line = core services ex-housing; grey line = core goods; yellow line = housing)

The second reason for ruling out a March cut is that Powell is less worried by inflation undershooting than I expected. When asked, ‘There are those on Wall Street who think if you maintain the level of restrictions you have right now, you could end up with inflation running below your target. How do you see that?’, Powell replied, ‘If we face those circumstances then we will have to deal with it.’ Answering a similar question later in the presser, he similarly replied, ‘we will be reacting to the data.’

That Powell is not concerned by the risk of overly tight policy was also shown by his rejection of the Taylor rule as a benchmark. When asked about the positive spread between FFR and various versions of the Taylor rule, Powell replied that the Fed ‘was not setting policy by them.’ My estimate of the Taylor rule shows the FFR spread is the widest since the 1980s, when inflation was higher and more entrenched than currently (Chart 2).

(Chart 2: orange line = actual FFR; blue line = Taylor rule; grey line = actual FFR/Taylor rule)

What Could Still Prompt a March Cut

I see two broad risks that could break Powell’s March guidance, but neither seem likely.

First, marked economic weakening. Powell said ‘If we saw an unexpected weakening in the labour market, that would certainly weigh on cutting sooner.’ But that is neither his expectation nor mine.

Second, a new banking crisis. A few hours before the FOMC, New York Community Bank, that acquired part of Signature Bank last year, cut its dividend and reported large commercial real estate (CRE)-related losses. Its stock price fell 46%, dragging the KBW index down 6%.

CRE loan losses are likely to rise across the banking system. But I do not expect a systemic crisis: commercial bank CRE lending represents $2.9tn out of assets of $23.3tn and against total tier 1 capital of $2.2tn, banks have been provisioning for CRE losses for some time, and CRE is a small share of the US economy. Losses are likely to be absorbed over time by bank equity holders.

Market Consequences

Following the FOMC, market pricing of the March meeting has barely changed, about 35% risk of a 25bp cut, against 40% before the meeting.

I think this is still too high since Powell made it clear this was not the Fed’s base case and neither economic nor financial instability appear likely at this stage.

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.)