FOMC Preview: Fed to Stick to Its Narrative

Summary

• The Federal Reserve (Fed) is likely to stay on hold and keep three 2024 cuts. This is because recent data indicates that January was a one-off inflation increase not the start of an upward trend.
• The Fed could lift its growth forecast but this would not impact the Federal Funds Rate (FFR) trajectory as recent data shows the regime of disinflation with strong growth continues.
• The Fed is likely to hint at a June cut based on continued sequential decreases in core Personal Consumption Expenditure (PCE), faster services disinflation, and continued labour market rebalancing.
• The Fed is also likely to communicate the broad contours of quantitative tightening (QT) tapering, including which indicator of reserves ampleness to use and the long-term composition of its securities portfolio.

Market Implications

• I agree with the market pricing a 75% chance of a cut by June and about three cuts by end-2024.

Fed Narrative: Disinflation Continues, But More Slowly

The Fed’s narrative centres on continued (if slower) disinflation, with three rate cuts in 2024.

The Summary of Economic Projections (SEP) shows core PCE slowing 80bp in 2024, compared with 1.2ppt/year in 2022-23.

Slower disinflation largely reflects smaller base effects and the broadening of disinflation to services that usually adjust more slowly than goods. The Fed is therefore looking for housing and supercore disinflation to accelerate in 2024 (Chart 1).

Until January 2024, disinflation was ahead of schedule. On a 6m SAAR basis, core PCE was 1.9% in November and December 2023, against an SEP forecast of 2.4% YoY Q4/Q4 2024 and below the Fed’s 2% target.

However, in January core PCE increased 42bp MoM, against an 13bp average for the previous three months. On a 6m SAAR basis, core PCE accelerated to 2.5%, still close to the SEP 2.4% YoY Q4/Q4 2024 forecast.

Yet I do not expect the Fed to change its narrative at the March FOMC for three reasons.

• Recent data suggests January was a one-off rather than the start of a trend.
• Core PCE remains close to the Fed’s 2024 forecast and 11 months remain to hit the forecast.
• The Fed believes its policy stance is restrictive.

February NFP, CPI Support Fed Narrative

Since the January PCE, the two most important data points have been nonfarm payrolls (NFP) and CPI.

The Fed believes wages are the main driver of supercore inflation. Therefore, the February slowdown in wage growth to 14bp from a 41bp average for the previous three months has likely reassured the Fed. Supercore disinflation will continue and the US is not experiencing a wage-price spiral (Chart 2).

The NFP also showed a marked recovery in immigrant workers, following a contraction in January. The Fed believes that foreign workers have played a key role in increasing labour supply and therefore the economy’s supply potential (Chart 3). This has allowed large increases in employment to have limited consequences for wages and inflation.

More broadly, the combination of a very large increase in NFP, 275,000, with a very low increase in wages suggests the regime of disinflation with low unemployment continues.

The second data point supporting the Fed’s narrative is the February CPI. While MoM core at 36bp was only 3bp lower than January, services inflation, which is more important to the Fed than goods inflation, slowed sharply.

PCE also usually prints lower than the CPI, and the CPI/PCE gap is currently widening due to growing CPI medical costs relative to PCE (Chart 4). This suggests February core PCE (released 29 March) will likely slow markedly.

That said, for all these positive factors, core PCE YoY at 2.8% is still above the Fed’s Q4 target of 2.4%. The Fed is still likely to cut because it views its policy stance as restrictive.

Fed Confident Policy Stance Is Restrictive Enough

Fed Chair Jerome Powell views the FFR as ‘well into restrictive territory.’ That is also what most Taylor rule estimates show. Chart 5 shows an estimate giving equal weight on inflation and unemployment based on core PCE. It shows the actual FFR well above the Taylor rule, for the first time since the 1980s.

While financial conditions have eased, they remain tighter than before the Fed started tightening (Chart 6). Most importantly, the Fed does not directly target financial condition indices (FCI). At the December FOMC, when asked about the impact of the Fed’s pivot on FCI, Powell replied: ‘in the long run, it’s important that financial conditions become aligned or are aligned with what we’re trying to accomplish. But in the meantime, there can be back and forth, and you know, I’m just focused on what’s the right thing for us to do.’

The Fed staff rely little on FCI, which they view as ‘providing a rule-of-thumb approximation of the effects of observed, and possibly endogenous, changes in financial variables on future GDP growth.’

With core PCE reasonably close to the Q4 target, a tight policy stance, and three quarters remaining before yearend, the Fed is likely to be confident that its current narrative will play out and keep three 2024 rate cuts in the SEP. It could raise its growth forecast for 2024 and 2025, but this is unlikely to impact the core PCE and FFR trajectories as recent data suggests the regime of disinflation with strong growth is continuing.

The Fed is now to provide guidance on the conditions for starting cuts.

Fed to Hint at June Cut

Starting at the January FOMC, Powell has repeatedly stated that he needs ‘more good data’ rather than ‘better data’ to start cutting. All FOMC members say they are in no rush to cut.  The Fed wants a balance between the risk of cutting too soon and ending disinflation before reaching the 2% inflation target and cutting too late and risking that inflation falls through the target.

I think the conditions for a cut include:

• Continued sequential decline in YoY core PCE.
• Faster housing and supercore services disinflation.
• Continued labour market rebalancing: i.e., stable to somewhat higher unemployment and YoY wage growth closer to 3.5% (2% inflation + 1.5% productivity growth) against currently 4.3%).

Growth above trend is less of an issue for the Fed if the above conditions are met.

By the June FOMC, the Fed will have seen three more PCE and NFP prints and four more CPI prints. Provided these meet the above conditions, the Fed would have enough confidence to start cutting. This would be consistent with Powell’s 8 March Senate hearing comment that ‘we are not far from having enough confidence to cut rates.’

Key risks that could bring rate cuts forward include economic weaknesses or banking distress, neither of which seem likely.

Key risks that could delay cuts include a marked increase in energy prices or economic overheating (see Disinflation Without Fiscal Consolidation?).

Fed to Decide Key Building Blocks of QT Taper

As Powell indicated, the Fed will start discussing QT tapering next week. Currently, the Fed is likely to focus on broad principles rather than produce a detailed schedule. Key issues to be agreed include:

Which indicator of reserves ‘ampleness’ to rely on. The Fed has an ample reserves operating framework. That is, it wants to supply banks with enough reserves so that these carry no convenience yield. Estimating when the quantity of reserves is close to an ‘ample level’ is complex.

Since the start of QT in June 2022, all the reduction in the Fed’s securities portfolio ($1.4tn) has been offset on the liabilities side of the Fed’s balance sheet by a $1.5tn decrease in Reverse Repurchases (RRP) (Chart 7). Reserves have increased $250bn, equal to 1ppt of banks’ assets.

Based on reserves alone, or on the residual $500bn RRP balance, some FOMC participants see a case to delay QT tapering. Others argue the decline in the Fed RRP has led to a widening gap between private RRP and other money market rates that is inefficient (Chart 8). They therefore argue for tapering sooner rather than later.

Long-term composition of the Fed’s securities portfolio. Several FOMC members, including Powell, have expressed preference for the Fed not holding any mortgage-backed securities on its balance sheet. FOMC members have also expressed a preference for holding shorter maturity Treasury paper, with Powell saying he could see a case for shortening the maturity of Fed holdings.

Market Consequences

I agree with the market pricing a 75% chance of a cut by June and about three cuts by end-2024.

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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.)