Federal Reserve Policy Signals

…It has begun. Over the last year, I have made the strongest possible case for the Fed to be proactive. Rates should have been cut this week – indeed, the rates should have been cut in January. We have seen this movie before. The Fed was very late to take inflation seriously in 2021. They brushed it off as “transitory”. However, it seemed obvious that inflation was surging. Real-time shelter inflation was increasing at a double-digit rate. Shelter has the largest weight in the CPI. Shelter operates with a lag. Hence, it was easy to forecast the surge. The Fed was forced to react after the damage was done. The same mistake has been repeated – despite many warnings. The recent CPI print was 3% year-over-year (YOY). Nearly two thirds of this print was driven by one component – shelter. Shelter inflation is reported at 5.2% YOY. This number is far from reality. For example, Apartmentlist.com rents are running -0.8% YOY - a full 6% below the official CPI number. Suppose we believe the real-time shelter inflation is 2%, not 5.2%. This means the real-time CPI would be 1.8%. If you believe shelter is 3%, then real-time CPI would be 2.2%. These numbers are well within the Fed’s target. The Fed prides itself on making data-driven decisions. However, it is unwise to make decisions based on stale data. The shelter inflation happened in the past. Keeping rates high will not impact what happened last year. It is always best to look at forward-looking indicators for policy decisions. ·      My yield curve indicator has been inverted for 20 months. It is 8 of 8 with no false signals since the 1960s. The maximum historic lead time has been 23 months (before the great recession). Ignore it at your own risk. ·      The Sahm Rule has been triggered. This indicator is not necessarily predictive because employment moves with the business cycle – but it is useful in telling us whether we are in a recession or not. We know that hiring has slowed and unemployment has risen – though the absolute rate is still relatively low. ·      Retail sales are highly correlated with personal consumption expenditures. Retail Sales are flat. Many do not realize that Retail Sales are not inflation adjusted. Taking inflation into account recent sales growth as well as YOY sales are negative. ·      There is considerable evidence that COVID-era savings have been drawn down. A recent release from Philadelphia Fed carried the headline: “Share of Delinquent Credit Card Balances Reaches Series High”. (The same report shows an alarming plunge in mortgage originations.) People are paying 20%+ interest on a card because their savings have run out. Indeed, if people are cutting back on fast-food expenditures, you know this is serious.  Drawing down the savings has fueled consumption expenditures over the past two years. That source of growth has ended. Now the Fed will have to play catch-up and cut by at least 50bp in September. Any recession is a self-inflicted wound. 

The Powell Pivot A few key words in the statement following the December FOMC meeting signaled a shift within the Fed about where it thinks it is its battle against inflation. It said that we might not need “any” additional rate hikes, given the credit tightening still in the pipeline and that “inflation has eased over the last year.” Inflation is approaching the Fed’s 2% target. The Fed didn’t declare victory or pop Champagne corks; it just acknowledged that we are closer than most expected to price stability. More importantly, Fed Chair Jay Powell pivoted from hedging against a more persistent inflation to experimenting with growth. He said ..”we are aware of the risk of hanging on too long…and we are very focused on not making that mistake.” That is a 180 degree shift from the Fed’s approach in 2022 and much of 2023. I remember well the 8 minute 34 second speech Powell gave at the Jackson Hole Symposium in 2022. It was like being doused in a bucket of ice. Powell made clear that the Fed would do whatever necessary to derail inflation, including triggering a recession. The comments by Powell at the December press conference represented a 180 degree pivot from that stance. The Fed did NOT commit to a March cut in rates nor did it fully slam the door on another. Instead it acknowledged how rapidly inflation has cooled without a consequential increase in unemployment. New York Fed President Williams further clarified that latter point to calibrate the knee jerk reaction by financial markets. He underscored that a rate cut is not imminent. That doesn’t change a few key issues: inflation is cooling and poised to cool further, the economy has weathered rate hikes remarkably well and the Fed doesn’t want to be the enemy of growth for no reason. If a little more growth enables an easier transition to full healing from the pandemic recession and the inflation it triggered, then that is something to lean into not against. When will the Fed cut? We still think May is more likely than March because improvements in inflation are likely to slow with a stronger consumer demand. However, stranger things have happened. Another nuance is that the Fed still believes the descent in rates will be slower than the ascent. The 2010s were the anomaly, not the norm.

It's no secret that I have been expecting a 50 basis point rate reduction at the upcoming FOMC meeting (September 18). Here are a few additional thoughts ... The Fed can either decide to tighten financial conditions or not. The futures market is currently pricing a 59 percent probability of a 50-basis point rate cut. Thus, unless something changes, going 25 will tighten financial market conditions, pushing interest rates up. Monetary policy works through the financial markets. Tighter financial conditions should be avoided when the balance of risks between growth and inflation have shifted as they have now. If the downside risks to employment outweigh the upside risks to inflation, then the Fed should be leaning against tightening financial conditions, all else equal. What are the chances of a hawkish 50 basis point cut? Powell may be successful in pushing through a 50-basis point rate reduction, but the projections show only a total of 75 basis points of rate cuts for the entire year. That would imply officials see only one more cut for the year, a hawkish sign. I am skeptical this will matter in the end. A “hawkish 50” is as unlikely as a “dovish 25.” In the former case, the dots will not be that significant. Powell will use the press conference to downplay them and stress these are conditional estimates. I am always reminded of what Yellen said back in 2014: “I think that one should not look to the dot plot, so to speak, as the primary way in which the Committee wants to or is speaking about policy to the public at large.” This is one reason I think going 50 or 25 is important. A popular argument goes like this: because many cuts are priced into the market the size of the move this week is not that important. I get it but believe this understates the significance in a few important ways. For one, the Fed’s policy rate is linked to prime rates. It’s the Fed’s rate not expectations that determine small business loans and auto loan rates, for example. Next, a big upfront move is a signal that the Fed means business about getting back on sides while a 25-basis point move with rates still far from neutral implies they are willing to leave a restrictive policy in place for a long time. 

Tuesday’s data on a number of key economic indicators suggested that the plane is about to land with further slowdown in growth and price gains observed in June and July. ⚠ All indicators came in lower than expected, implying that while the economy has remained resilient, it has lost some momentum as the Fed continues to press on the brake with more rate hikes. 🧊 Job openings fell to the lowest since April 2021 while the vacancy-to-unemployed ratio rose slightly to 1.6 in June. Together with a sizable downward revision to May’s opening data, the labor market has loosened quite fast in the last couple of months. ⤵ One key data point that the Fed is also looking at is the quit rate, which fell to 2.4% in June from 2.6% earlier. Job quits have been one of the most important factors that drive wage growth. With quit rates continuing to stabilize, the concern over a wage-price spiral should be put behind us in no time. 🔴 A slight uptick in the ISM manufacturing index was not enough to keep the sector out of contraction territory in July. Prices paid, the subindex for inflation, showed drops in prices for the third straight months, pointing to further disinflation from the goods sector. 🔑 Tuesday’s data supports our base case that July should be the last time we see a rate hike. We have updated our recession probability downwardly to 60%, which means it will be a lot harder to predict which outcome it is going to be as the economic signals moving forward will be both soft-landing-ish and recessionary. 

The Fed lowered Fed Funds today by 50 bps to 5.0%. 11 of the 12 Fed governors backed the idea. They also shared their quarterly projections, targeting another 25 bps cut in November and 25 bps in December. So, if that holds, by year-end, we will have a 4.5% Fed Funds. For perspective, cutting rates usually is done to provide some financial relief in a struggling economic environment. The S&P 500 hit another record high on the news. The Fed policy statement said: "The committee has gained greater confidence that inflation is moving sustainably toward 2%, and judges that the risks to achieving its employment and inflation goals are roughly in balance." The 10y UST was at 3.64% on the news, up slightly from a 52-week low earlier this week. When the long end drops it can be a bearish signal as people are buying more bonds as a safety investment, pushing down rates. So you have the bond market signaling recession while the stock market is signaling that all is well. What a moment. I must admit I have a hard time reading the tea leaves on this one. Why did they cut 50 and not 25? Perhaps they know something I don't (and go ahead, make a joke, I'm an easy target!). Perhaps they are worried about the interest payments being the 2nd biggest line item in the Federal budget. But seriously, a 50 bps cut feels to me like a crisis cut. This is a policy change moment, to be sure. We all knew it was coming because Powell telegraphed it for months, especially at Jackson Hole. But the economy is doing very well, and top-line macro indicators look good. It is two months before a major presidential election where the incumbent is out of the race. To the point about inflation being subdued, I would be remiss if I didn't point out that housing prices are up 6.7% YoY as of August, which, granted, is lower than previous prints, but is still well elevated. Housing prices are the biggest component of the Core CPI. We are all living with the consequences of astronomical increases in housing prices. Perhaps the Fed thinks that by lowering Fed Funds this much, it could jump-start supply in the housing market, bringing people off the sidelines to sell, and to buy, potentially lowering prices as an equilibrium is found. I don't know. With this move we should expect to see a mini-boom for gold prices. Gold started the year at $2000, and now it's $2600 an ounce - a 30% increase YTD. The "barbarous relic" has for thousands of years been a safe-haven investment. Could be a driver of its bid. I'll have more to say about this move in the coming days. Need to think about it. But I am surprised they cut 50 and not 25. #fedpolicy #riskmanagement #interestrates

PCE Report Supports September Rate Cut. Strong consumer spending growth is not sustainable. The July report on Personal Income and Outlays continues a string of recent inflation reports that are broadly supportive of an interest rate cut by Federal Reserve policy makers when they meet next month. PCE Inflation held steady on a year-over-year basis at 2.5%, only a half-point above the Fed's long-run 2% target. There was continuing progress on the categories that have bedeviled the Fed since inflation began to recede from its mid-2022 peak. In particular, inflation of non-energy services other than housing rose just 0.2% on the month, or 2.4% on an annualized basis, below the 2.8% change over the past six months, and down sharply from the 4.4% change for the six months ending in March. Looking at changes over a number of months helps smooth out the volatility inherent in monthly changes. Housing cost inflation is the key remaining category that is keeping PCE inflation above the Fed's 2% target. These prices ticked up 0.4% in July, but have been trending down and are running at nearly 5% on a trailing 6-month basis. Goods price inflation is non-existent, and energy prices are flat over the past six months. There is nothing here that would cause undo concern to the Federal Reserve. On the spending side, real personal consumption rose 0.4% in July, equal to the average of the past three months, and confirming that spending is holding up well. Over the past year, real spending has risen 2.7%, with strength in spending on both goods and services. This high rate of spending, while confirming the strength of the consumer sector, is likely not sustainable. The growth of personal outlays has exceeded the growth of disposable personal income for the past half-year, and the savings rate declined below 3% in July, just half the average of the 2013-2019 period. This, together with much softer labor markets and rising delinquencies on short-term borrowing, means that consumer spending will have to slow in coming months. This is the primary reason that overall economic growth, measured by real gross domestic product will decelerate in the coming months, to below 2% or further. This is an all-around positive report, confirming both that households continue to support growth and that inflation remains well in hand and is likely to continue to ease. We will get one more important economic report—on labor market conditions—next week, but the stage is set for a Fed rate cut in September. #PCE #inflation #consumerspending #federalreserve #interestrates

Pondering the Fed's Next Move - let me jump to the conclusion: The Fed is unlikely to cut rates anytime soon and market expectations continues to be wrong. I expect the FOMC to delay policy easing until inflation data falls to its 2% target, or employment/economy show a marked decline. Economist and the financial markets have concluded that inflation is on a glidepath towards the Fed’s 2% target (CPI/PPI currently in the 3-4% range). If inflation declines to 2% in the coming year, it’s likely the result of lower demand, or slower GDP growth rates. It is remarkable that we could be talking about a 2% inflation path given the resilience of GDP and employment growth rates. The Federal Reserve’s economic models suggest that a neutral Fed Funds rate is one that is consistent with 2% inflation and full employment. If we arrive at this point, there will be no need to cut rates at all, a condition that the economic models will surely support. In other words, with growth and 2% inflation, current Fed Funds might just be necessary, negating a pivot to lower rates. The Fed will move slowly. Remember, these are the same policy folks who made significant output errors with respect to their inflation forecasting models, so they might be hesitant to lower rates too quickly, especially since employment and economic growth remains resilient. Fed policy makers are asking themselves this question: if we lower rates, will this policy action re-stimulate inflation and growth? If you were Powell, what would you do under these circumstances? Currently, inflation remains stubbornly above the Fed’s target, so I don’t expect the Fed to cut rates until we see material economic weakness which will likely not be confirmed prior to its June ’24 meeting. What makes this particularly tricky for the Fed is that after June, its subsequent meetings are July 31 and September 18, just prior to the U.S. Presidential Election. The Fed certainly does not want to be appear political by easing right prior to the November 5th election. If the Fed don’t move by June, might they wait until the November 7th meeting, which falls 2 days after the election? This game theory presents an interesting dynamic, and avoiding politics is precisely why Chairman Powell emphasizes that the Fed remains data dependent. Chairman Powell acknowledges the progress on inflation, but suggests restrictive monetary policy will be warranted, thus implying ‘Higher for Longer’. Chairman Powell: "Recent declines in measures of underlying inflation, stripped of food and energy prices, were welcome, but two months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably... Restrictive monetary policy will likely play an increasingly important role. Getting inflation sustainably back down to 2% is expected to require a period of below-trend economic growth as well as some softening in labor market conditions."

The Federal Reserve’s half-point cut in the Federal Funds Rates signals both the end of its fight against high inflation and a renewed focus on supporting the labor market. Chair Powell’s speech in Jackson Hole last month previewed this shift toward protecting the labor market, and those words are now turning into action. Powell and other policymakers openly acknowledged the risks to the labor market are growing, with 12 participants indicating unemployment risks were increasing, up from only 4 in June. The median projection for the unemployment rate for the end of this year and 2025 increased to 4.4%, from 4% and 4.2% earlier this year, signaling the Fed expects the labor market to soften further. With inflation trending toward 2 percent, a smooth landing can happen if actual data comes in as projected. But whether or not the pilot lands the plane skillfully depends on whether the pullback in interest rates is large enough and quick enough. The descent is going well so far, but the plane is not yet on the ground.

What to Watch for in the Markets This Week: CPI, PPI, and Key Indicators to Gauge the Fed's Next Move This week brings a slew of important economic data that could help us predict whether the Fed will lower interest rates by 25 or 50 basis points on September 18th. Let’s break down what to watch this week: Wednesday, September 11: The Consumer Price Index (CPI) and Core CPI** If inflation is high, the Fed may be cautious about making aggressive rate cuts, as it could risk stoking inflation further. In addition to the broad CPI, we’ll also be looking at the **Core CPI**, which excludes food and energy prices. Why exclude those? Because food and energy prices are highly volatile and can skew the broader inflation picture. By focusing on Core CPI, we get a clearer view of underlying inflation trends without the noise from short-term fluctuations in oil or grocery prices. If the Core CPI comes in lower than expected, it could signal room for a more aggressive 50 basis point cut. Thursday, September 12: Initial Jobless Claims and PPI Initial Jobless Claims - This number tells us how many people are filing for unemployment for the first time. Rising jobless claims typically indicate a weakening labor market, which could put more pressure on the Fed to cut rates to support job growth. Producer Price Index (PPI) - which measures the average change over time in the selling prices received by domestic producers for their output. Like CPI, there’s a core version of the PPI that excludes food and energy prices to give us a clearer view of inflation trends without short-term volatility. For Thursday, it’s critical to focus on the **PPI for food and energy**, as those sectors often see the most price movement. If food and energy prices are rising rapidly, it could indicate that inflationary pressures are building, which might make the Fed more cautious in its rate-cutting approach. Friday, September 13: Michigan Consumer Sentiment Index The last big indicator to watch this week - this measures how optimistic or pessimistic consumers are about the economy. If consumer sentiment is strong, it suggests that people are still confident in their financial prospects and likely to continue spending, which could point toward a smaller rate cut. On the other hand, a drop in sentiment could be a sign that consumers are growing wary of the economic outlook, which might prompt the Fed to take a more aggressive approach to stimulate growth. What Does This All Mean for the Fed’s Decision? Lower CPI, PPI and Higher Jobless Claims = 50 Basis Point Cut from the Fed is likely. Sticky Inflation, Strong Consumer Sentiment = 25 Basis Point Cut from Fed is likely. Either way, this week’s numbers will give us plenty of clues about the Fed’s direction!

TL;DR: October's inflation data "deflated" worries from last month about a sustained upturn, though we haven't seen marginal improvement since early summer. The stage is set for the Fed to lower policy rates at least a little. This morning my friend Matthew Darling at the Niskanen Center joked, "Inflation is over Guy. We can be labor economists again. We're free." Well, not quite, but we're not far away. After a run of steadily improving consumer price index (CPI) data during the first 7 months of the year, August and September CPI were a little worrisome because they ran hotter. For "hawks" who have been worried about a still-warm labor market creating price pressures, this showed signs of a renewed inflation uptrend. The good news is that October's data was much more benign. The underlying trend measures I like to follow (core, median and trimmed mean CPI) all improved substantially in M/M terms (ranging from 2.8% annualized on core to 3.9% annualized for median). Once you account for the fact that the CPI runs hotter than the Fed's preferred measure (the PCE price index), we're really not far from the Fed's target. On a 3M annualized basis things were somewhat less peachy - these same metrics ranged 3.4%-4.5%, a huge improvement from a year ago (6.1%-7.8%) but a slight deterioration from two months ago (2.4%-3.6%). Y/Y versions of these metrics, which get the headlines but are somewhat laggy, are the best they've been in 18-24 months. Despite lack of recent improvement, there is scope for underlying inflation to move down further in the coming year based on how the rent components of inflation are calculated. Even if inflation is not quite back at the Federal Reserve's 2% target, it is likely that they'll see the improvement in inflation to-date sufficient to convince them to lower their policy rate at least a little - probably not at their December meeting, but during the first half of next year. And that's even if the labor market remains healthy - no recession required.