The Fed Is Out to Cut

Summary

• The Fed has shifted its focus from stabilizing inflation to supporting growth and asset prices, which suggests frontloaded FFR cuts.
• If the soft-landing scenario the Fed is hoping for materializes, inflation will be practically back at target by end 2024, which could see the Fed cut, conservatively, by 200bp in 2024.
• In a muddle through scenario, where inflation remains stuck around 3%, the Fed could still squeeze in one or two cuts in H1.
• If Fed policy turns out too loose, the inflation consequences likely won’t be felt until end-year.

Market Implications

• The market is pricing too few cuts for a soft-landing scenario and too many for a muddle through scenario. In addition, the market is pricing mainly H2 cuts when cuts would likely be frontloaded.

Fed Out to Cut

The Fed’s surprise pivot is a change in objective function rather than a reaction to data surprises, as I initially explained in my FOMC review. The Fed is now focusing on growth and asset prices from previously inflation stabilization. (As always, I am focusing on what the Fed might actually do, as opposed to what I think it should do).

My evidence is:

Unclear data trigger for the pivot. The last PCE print released on 30 November, at 16bp, brought six-month annualized core PCE to 2.5%. New data after 1 December, when Powell said it was premature to discuss cuts, signaled rising rather than falling inflation risks.  November NFPs showed continued strong growth and November CPI showed that inflation could be troughing (see NFP and CPI reviews). The Atlanta Fed Q4 GDP nowcast jumped to 2.3% on 8 December from 1.2% on 7 December.

Powell has turned more sanguine on disinflation progress so far. For instance, on 1 December Powell characterized wage growth as ‘high’ but 1.5 weeks later as ‘running a bit above what would be consistent with 2 percent inflation.’ In reality median wages, whether ECI or Atlanta Fed (the former is the Fed’s preferred measure of inflation), are still about 1.5ppt above pre-pandemic levels (Chart 1).

Powell is no longer concerned by the impact of looser financial conditions. Powell stated: ‘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.’ Because the Fed believes that policy changes get transmitted through financial conditions, Powell’s comments suggest more focus on supporting growth and less focus on supporting disinflation.

Powell prefers faster growth to faster disinflation. In response to the question: ‘is growth below trend necessary to cut rates?’ Powell stated: ‘if we have stronger growth that will be good for people. That will be good for the labor market. It might actually mean that it takes a little longer to get inflation down to two percent.’

The Fed has become more dovish than other global central banks. The Fed pivoted ahead of ECB and BoE, even though US growth or inflation trends have been stronger than in these jurisdictions (Chart 2 and 3).

There is a precedent for the Fed cutting rates when the economy is strong: in 2019, the Fed cut 75bp even though unemployment was below 4% and falling. The cuts were largely in response to asset price weaknesses.

More broadly, the Fed has a long-established track record of boosting asset prices, enabled by the low inflation environment prevailing since the mid-1990s. Since the GFC, asset price inflation (or the ‘portfolio balance effect’) has become an official channel of policy transmission.

The Fed default position seems now to cut. In this note I look at how it could go about it.

Fed Cuts: Earlier Is Better

For all the Fedspeak and transparency, the Fed has actually a great deal of leeway in setting up policy. First and foremost, this is because monetary policy setting is more art than science.  In addition, inflation has inertia, so the recent slowdown is likely to persist for a while. Finally, inflation prints are noisy: it takes time for a new trend to become apparent (Table 1).

The other source of leeway for the Fed is the long time frame it set out to bring inflation back to target, namely by end-2026. With 2023 Q4/Q4 core PCE at 3.2%, down from a peak of 5.6% in February 2022, the Fed is already two thirds of the way to the 2% target. It still has three more years to get through the last third.

Boosting growth requires a different game plan compared with stabilizing inflation. For instance, it suggests upfront cuts, so the cuts have a chance to transmit to the real economy.  By contrast, stabilizing inflation suggests backloading cuts to ascertain that disinflation is on a sustainable path.

In addition, as Powell stated during the presser, the Fed will not attach much weight to signs of resource pressure and overheating, for instance, low unemployment or above trend growth. Instead, the pace of cuts is likely to be driven by PCE prints.

I now look at three rate cuts scenarios based on three inflation scenarios.

Three Scenarios

I am assuming no recession next year due to lose fiscal policy, monetary policy easing, and strong households balance sheets.

Throughout the presser, Powell repeatedly stressed that the Fed would ‘proceed carefully.’  This suggests no cuts in January, but a scenario analysis suggests a cut is likely in Q1 (Chart 4).

Soft-landing scenario. If core PCE hits the SEP 2024 target of 2.4%, which would work out to average MoM prints of 20bp (the average of the past six months), Powell will go down as the most successful Fed chair in history, as the Fed will have effectively managed a soft landing.  The Fed has never managed such a feat when it started so far behind the curve.

In addition, for all practical purposes, the Fed will be back to the 2% target by end-next year.  That is why in this scenario the Fed is likely to cut by much more than the 75bp currently in the SEP. Table 2 shows 200bp in cuts, that would bring the end-2024 to 3.4%, still well above the SEP end-2025 and 2026 FFR at 3.6% and 2.9%, respectively. So my rate cut scenario is probably on the conservative side, if inflation follows a smooth path to 2.4% Q4/Q4 2024.

The reason the SEP is only showing three 2024 cuts could be because the Fed is not confident that disinflation will smoothly proceed to its 2024 forecast.

Muddle through scenario. If core PCE was moving sideways, i.e., around 25 bp/month, which would leave 2024 Q4/Q4 PCE at 3%, unchanged from current levels, the Fed would likely squeeze a couple of cuts in H1, before it became clear that inflation is not slowing. The Fed could justify these cuts by arguing that it still has three more years to go back to target.

High inflation scenario. If core PCE was moving at around 30bp/month, which would leave 2024 Q4/Q4 PCE at 3.7%, from 3% in October 2023, the Fed would find it difficult to cut.  Higher inflation would likely be unpopular with voters.

What Could Go Wrong?

Plenty, but likely not right away. In fact, Fed easing could be followed by further disinflation.  For instance, lower mortgage rates could see higher inventories of properties for sale or rent and therefore allow vacancy rates to normalize. In such an instance, housing costs could slow (Chart 5).

Long-term, the biggest risk is that inflation is not on the downward trajectory the Fed expects. In my view, besides the normalization of the pandemic demand and supply shocks, disinflation reflects lower oil prices and poor transmission of strong growth to wages (see Fed Preview). For instance, a stabilization of oil prices could place US inflation in the ‘muddle through’ rather than the ‘soft-landing’ scenario.  Worse still, an oil price shock could reverse most of the disinflation progress so far, though this is not my base case scenario.

Furthermore, the easing of financial conditions and higher asset prices could support stronger demand, which would place a floor on inflation, though this would likely happen towards end-year (see Antonio’s A Possible Surprise for 2024).

More broadly, Powell is broadly applying the 2019 playbook even though this time around core PCE is 3.2% against less than 2% in 2019. The US economy then was in a low inflation regime, and the cuts had no immediate consequences for inflation. This time around, the consequences could turn out less favorable, though they may not play out until after the presidential elections.

Market Consequences

The market’s six cuts by December 2024 are either too large for the ‘muddle through’ scenario or too little for the ‘soft-landing’ scenario. In addition, since the Fed focus has shifted to stimulating growth, the cuts are likely to be more frontloaded than the markets are pricing.

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.)