Monetary Policy & Inflation | US
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
Summary
- Since the 29 January FOMC, data releases have generally been towards increasing inflation risks.
- Transmission of Fed easing to the real economy has been unequal. Household wealth has risen but credit growth remains weak.
- Recent Fedspeak shows the FOMC are wondering whether policy is restrictive enough. This creates risk the Fed could end its easing bias this year.
- The Fed could suspend quantitative tightening (QT) until the debt ceiling has been lifted.
Market Implications
- I expect no Fed cuts in 2025 against market pricing 1.6 cuts.
Rising Inflation Risks
At the 29 January FOMC, Chair Jerome Powell repeated that actual disinflation progress would be needed for further cuts and the Fed’s economic assessment was unchanged. Economic activity was expanding ‘at a solid pace’, labour market conditions ‘remained solid’, and inflation ‘remained somewhat elevated relative to the Fed target.’
Subsequent releases have generally been towards greater inflation risks.
Trend GDP growth has remained above 3%. A slowdown in headline growth in Q4 reflects largely inventories changes and net exports (Chart 1). The Atlanta Fed Q1 GDP nowcast is down to 2.3% QoQ SAAR but this reflects the recent start of the nowcast on 31 January and volatility of earlier data releases (Chart 2). The nowcast is likely to rise nearer GDP trend as more high frequency data becomes available.
The labour market has remained tight. Even after the annual benchmark revisions, MoM nonfarm payrolls (NFP) remain volatile but the 3mma and 6mma show an upward trend (Chart 3). Also, January unemployment fell to 4%, while wage growth remained sticky (Chart 4).
Inflation risks have increased. January core PCE rebounded to about 27bp, compared with the previous six-month average of 19bp while supercore has been sticky, and goods deflation is ending (Chart 5). Labour productivity growth is slowing, and labour costs are rising (Chart 6).
Inflation expectations have been rising, with the February University of Michigan 1yr expectations spiking (Chart 7). Demand pressures are getting stronger as shown by the worsening of the external balance, though it partly reflects front running of tariffs increases (Chart 8).
Limited Policy Transmission to Real Economy
Policy easing has not fully transmitted to real the economy. Following the Fed’s 100bp cuts since mid-September, the market-based Financial Conditions Index (FCI) is 0.3 higher despite a 60bp increase in 10yr yields (Chart 9 and 10; the FCI is expressed in z-score). The market-based FCI is composed of credit spreads, equity prices and volatility measures. Its resiliency reflects the strong equity market performance that strong AI optimism has driven.
The Fed’s FCIs that, in addition to financial market variables, include house prices and the dollar index, also show easing, though they suggest financial conditions are still detracting from growth (Chart 11).
Real economy data reflects these mixed signals. On the one hand, household wealth remains well above, and household debt service below, pre-pandemic levels (Chart 12). On the other hand, private sector borrowing is much lower than historical norms (Chart 13 ). This reflects that Fed easing transmits quickly to equity prices and that equities account for about one-fourth of households assets. By contrast, the impact of Fed easing on bank credit is slower as it works through balance sheet and collateral effects.
Overall, Fed easing has had only a limited impact on the most interest-rate-sensitive components of demand (Chart 14). The limited impact on residential investment reflects largely that mortgage rates are up 50bp since the Fed started easing! Also, the mortgage lock in effect is a form of extreme financial tightening.
While durables goods consumption has been growing strongly, it is unclear whether Fed easing played much of a role. Durables goods consumption has been picking up since mid-2022, despite 425bp in Federal Funds Rate (FFR) hikes! (I intend to address these issues in greater detail in future research).
Most importantly, with inflation risks rising it is unclear whether the US economy needs more Fed easing currently.
Will the Fed End Its Easing Bias in 2025?
Following the US election, I changed my 2025 Fed call to not cuts, based on inflation risks. Since then, the market has moved in my direction and my very simple Taylor rule, a good predictor of Fed policy this cycle, continues supporting this view (Charts 15 and 16).
On balance, I see the next Fed move as more likely to be a hike than a cut but until recently I expected the Fed to maintain its easing bias through 2025. The data developments discussed above together with recent Fedspeak suggests a growing risk the Fed could end its easing bias this year.
Following President Donald Trump’s tariffs announcements, FOMC members have indicated an extended pause (Table 1). Except Governor Christopher Waller, they believe that with a strong economy, policy is well placed to stay on hold until there is more clarity on the administration’s policies.
Cleveland Fed President Hammack, one of the more hawkish FOMC members, hinted in a 11 February speech that Fed policy may not be restrictive enough (Table 2). She said, ‘while there are good reasons to expect that inflation will gradually come down to 2 percent over the medium term, this is far from a certainty, and upside risks to the inflation outlook abound. The ongoing strength in consumer spending bears watching to see whether it is consistent with easing inflation.’
The Fed minutes released today suggest other FOMC members have doubts on the restrictiveness of monetary policy. They said, ‘Many participants emphasized that additional evidence of continued disinflation would be needed to support the view that inflation was returning sustainably to 2 percent.’
The minutes further noted: ‘Some participants noted that some market- or survey-based measures of expected inflation had increased recently.’ Central bankers dread de-anchoring inflation expectations since it implies a credibility loss and much higher costs of lowering inflation. This adds to the risks of the Fed ending its easing bias this year.
In addition, the minutes were more explicit (and less diplomatic) than Powell in discussing the inflationary risks associated with the administration’s policies: ‘Other factors were cited as having the potential to hinder the disinflation process, including the effects of potential changes in trade and immigration policy as well. Business contacts in a number of Districts had indicated that firms would attempt to pass on to consumers higher input costs arising from potential tariffs.’
For now, I maintain my view that the Fed will keep its easing bias through 2025 but further data or Fedspeak suggesting inflation risks could change this view.
Lastly, the Fed minutes highlighted the risk the FOMC could decide to end QT until the debt ceiling had been raised (Chart 17 and 18). This would be to ‘the potential for significant swings in reserves over coming months related to debt ceiling dynamics.’
Market Consequences
I expect no Fed cuts in 2025 against market pricing 1.6 cuts.