Monetary Policy & Inflation | US
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Summary
- The Fed has cut 50bp and lowered the FFR path despite risks of inflation stickiness.
- The Fed move shows strong sensitivity to employment data.
- The Fed is likely to cut sooner and more if NFP and unemployment are weaker than it expects but may not react to weaker NFPs if they are accompanied by lower unemployment.
Market Implications
- I expect the Fed to cut twice more in 2024 at the November and December meetings.
Fed Comfortable With Inflation Above Target, for Now
At the September 18 meeting, the FOMC cut the FFR 50bp and lowered its trajectory 75bp at end-2024 and 2025 (Table 1).
Fed Chair Jerome Powell cited as reasons for move:
- Fed patience in not cutting earlier (in plain English policy was tight, Charts 3 and 4).
- NFP, QCEW and Beige Book had signalled rising employment risks. Powell added that had the Fed seen the July NFP report before the 31 July FOMC meeting it ‘might’ have cut then.
The move shows the Fed is comfortable, for now, with inflation above 2% as core PCE has troughed around 2.6% (Chart 7). Recent inflation prints have been favourable. The Fed estimates August core PCE MoM at 14bp, which brings the three month change annualized to 1.9%. Post FOMC meeting, Governor Christopher Waller cited this estimate as the factor that tipped him towards 50bp, instead of 25bp as his 6 September speech implied. That said, core PCE has gone through repeated short cycles and the data does not yet signal a clear downward trend (Chart 7).
Also, shelter inflation (accounting about one fifth of core PCE weights) remains above 5% YoY and has reaccelerated over the past two months (Chart 8). In the presser, Powell expressed confidence shelter disinflation would eventually happen ‘provided market rents remain relatively low’ (market rents are rents paid by new tenants).
Fed Highly Sensitive to Employment Risks
The Fed cut to reduce downside risks to the labour market rather than to respond to actual economic weaknesses. Growth remains above trend and the external balance is worsening, suggesting domestic investment is growing ahead of domestic savings, i.e., the economy is overheating (Charts 9 and 10).
The Fed has reacted strongly to the slowdown in NFP since June. However, NFP volatility was more pronounced in 2019, when according to the Powell the labour market was ‘very strong’ (Chart 12). Currently, labour market indicators broadly suggest strength (Charts 11-16).
Whatever the Fed’s reason for starting its easing cycle with a 50bp, it is clearly very sensitive to labour market data, especially NFP.
Greater Employment Risks to See Faster, Deeper Cuts
Over the remainder of 2024, the Fed faces two major uncertainties. First, the labour market could be weaker than I expect. For instance, should the September employment report show, e.g., sub 100,000 NFP and an increase in unemployment, the Fed would likely cut 50bp in November.
Second, immigration could already be falling as suggested by fewer Border Patrol encounters with undocumented migrants (Chart 17).
A decline in immigration is negative for growth but could see a decline in unemployment as there is evidence migrants take longer than native-born workers to find jobs (see NFP review). Also, NFP growth would slow since there would be fewer workers available.
How would the Fed respond to lower unemployment and slower NFP growth?
It would likely focus on unemployment as it is concerned with the balance between demand and supply of labour rather than only with demand. But provided inflation remained in line with its forecast, the Fed would likely stick to its easing plans even if unemployment turned out lower than it expects.
The impact of lower immigration on inflation is ambiguous. Fewer migrants could reduce the demand for housing and support housing disinflation. On the other hand, it could also imply higher wage growth. Real wage growth has been abnormally low during the recovery, and the growth advantage of low over high wages has narrowed considerably, possibly due to immigration.
That said, inflation is unlikely to prevent further easing in 2024. First, the June SEP showed the Fed ready to cut once in 2024 even though it forecast Q4 core PCE at 2.8% YoY. This suggests core PCE would likely have to exceed 3% for the Fed to stop cutting.
Second, for core PCE to hit 3% Q4/Q4, monthly prints would have to average 30bp, which seems unlikely as the past three months averaged 15bp and the past six months 19bp. If monthly core PCE remains at 19bp until the end of the year, the Fed will meet its core PCE forecast of 2.6% Q4/Q4.
Market Consequences
I expect two more cuts in 2024 against the market pricing three.
Current Fed Macroeconomic Forecast
Recent FOMC Comments
Fed Lowers FFR Path
Inflation Has Troughed, Growth Remains Above Trend
Fed Focused on Employment Risks
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.