Stephen Miller

Fed: Pamplona in the markets!

As was widely anticipated, the US Federal Reserve’s (Fed) Federal Open Markets Committee (FOMC) opted to eschew any adjustment in the policy rate at the conclusion of its meeting on Wednesday.

However, the Fed did send a clear signal that the process of policy rate increases is at an end and that there is a strong likelihood of policy rate cuts in 2024. In so doing, it tempered its previous “high for longer” mantra.

The median “dot plot” projects a policy rate of 4.6 per cent by end-2024 down from the 5.1 per cent projected at the September meeting but above the low 4’s that the bond market had projected prior to the release of the Fed decision.

Nevertheless the “pivot” unleashed a strong rally in bonds and equities as markets rushed to embrace a “soft landing” / “immaculate disinflation” scenario.

That occurred despite a somewhat circumspect Fed Chair Powell saying that the projections are not a pre-set plan, and that the Fed policymakers aren’t ready to take further interest-rate increases off the table if needed to quash resurgent price pressures.

Powell’s circumspection may reflect some lingering (but clearly diminished) anxieties surrounding the pace at which inflation is falling.

There was a significant revision downwards from September in the median projection of the Fed’s favoured core personal consumption expenditures (PCE) price index measure for 2023 to 3.2 per cent from the 3.7 per cent projected in September. The 2024 projection is revised slightly downwards to 2.4 per cent from the 2.6 per cent projected in September. Those forecast revisions explain downward adjustment in the median policy rate “dot plot” for end 2024.

The November consumer price index (CPI) report on Wednesday was probably marginally disappointing from the Fed’s perspective insofar as measures of the inflation pulse appear to have stalled in terms of their earlier downward momentum, particularly on the services side.

However, there has been clear “over-achievement” on core PCE – the Fed’s preferred inflation measure.

Reflecting better than anticipated outcomes so far in calendar 2023, GDP growth for 2023 and 2024 was revised upwards to 2.6 per cent in 2023 from 2.1 per cent in September. However, GDP growth for 2024 was revised down to 1.4 per cent from 1.5 per cent in September. The unemployment rate for end-2023 and end-2024 were unchanged from September at 3.8 per cent 4.1 per respectively.

While there remains a little distance in terms of the magnitude of rate cuts between the Fed and the bond market, that the Fed has clearly moved on from “high for longer” was sufficient to continue the positive momentum – even exuberance – in financial markets. Markets are now clearly embracing a scenario where the Fed successfully “threads the needle” and achieves an “immaculate disinflation” where inflation returns to target without any meaningful dislocation in employment and activity.

There are, however, risks that go both ways.

The first, and more probable in my view, is the one that most troubles the Fed: that inflation remains stubborn. That doesn’t obviate rate cuts but diminishes their magnitude and frequency.

The second is that the economy lurches into weakness. In this construct much of the unexpected strength in the US economy this calendar year was the product of an injudicious fiscal expansion through 2023. That might also account too for some of the “stickiness” in inflation. An inevitable fiscal contraction in 2024 might unleash a “payback” in terms of a more marked slowdown in growth, perhaps bordering on recession and perhaps greater disinflation. Here, policy rate cuts are greater, but they take place against a background of debilitated growth – bonds rally but equities languish.

Nevertheless a “hybrid” benign Fed / market scenario – as improbable as it seemed until recently – looks the most likely. Even if markets are a little too extended in the short term, a cocktail of lower inflation, moderate growth and policy rate cuts is a powerful tailwind.

That there are few historical precedents for such an end to a tightening cycle is worrying, but – at the risk of invoking one of the more dangerous sentiments in markets – “maybe this time really is different”!?

Coming up: ECB and Bank of England – both on hold

ECB: overachieving on inflation implies an end to the tightening cycle

The normally hawkish European Central Bank (ECB) Governing Council member, Isabel Schnabel has made this particular ECB meeting somewhat of a formality given her comments on 5 December that given a “remarkable” fall in inflation any suggestion of a further increase in the ECB policy rates was off the table for this meeting and maybe in abeyance indefinitely.

Schnabel added that she had had shifted stance after three unexpectedly benign inflation readings in a row.

In that context ECB policy rates on the deposit facility, main refinancing operations and marginal lending facility will remain at 4.00 per cent; 4.50 per cent; and 4.75 per cent respectively.

That Eurozone-wide growth measures remain frozen only adds to the case.

What also made Schnabel’s comments arresting was her added comments that policymakers should not guide for rates to remain steady through mid-2024.

That may be fair enough, but I wonder if markets have taken that a little too far in terms of the magnitude of cuts now priced in in Europe (circa 130+basis points for 2024).

In any case the key focus will be what guidance, if any, ECB President Lagarde gives post the meeting.

As is the case elsewhere, she may be disposed to push back a little given the orders of magnitude of the cuts priced. As good (or “remarkable”) as the progress has been, the fact remains that core CPI is around 3.6 per cent and the ECB’s favoured core harmonised index of consumer prices (HICP) is still running at 4.2 per cent. To endorse current market pricing when inflation so measured is still some way from the 2 per cent target might excite an exuberance in markets (in terms financial conditions) that might frustrate the achievement of the inflation target.

In this context while I would expect Lagarde to herald the “remarkable” progress on inflation, and she may open the door to policy rate cuts in 2024, but not to the same extent as market pricing of policy rate cuts.

Bank of England: lagging the pack

Perhaps the Bank of England (BoE) can dare to think that they might finally be getting on top of inflation.

The October CPI report revealed that on a core basis annual inflation fell to 5.7 per cent from 6.1 per cent in September.

And like the Fed, markets anticipate that the cyclical high for the policy rate has been achieved.

However, markets may be waiting for some time to commence the downward policy rate journey.

Indeed, the UK economy exhibits some characteristics that suggest a greater inflation proclivity. These include :

• Stronger worker resistance to real wage erosion. These were in evidence in the October wage numbers showing ongoing strong wage growth (7.9 per cent including bonus; 7.7 per cent ex-bonus).
• Ongoing disruptions to external trading relations post-Brexit that have slowed supply chains and a lower degree of internal economic flexibility leading to productivity challenges.
• Limited government effort toward supply-side enhancement.

The latter two points were in large measure a consequence of the mismanagement of Brexit occasioned by a distracted (even indolent) Johnson Government and the turmoil wrought by the fleeting Truss Government.

The BoE was also complicit in the UK’s relatively poor inflation performance. Throughout 2022 it exhibited not a small amount of prevarication in assuming a frontline role in fighting inflation – less so in 2023.

That said, given a revealed preference to “hold” at both the September and November meetings it is hard to see the BoE adjusting the policy rate when it meets this evening. Moreover, given the particular inflation proclivities of the UK economy, policy rate cuts seem a more distant prospect there.

The post Pamplona in the markets and the European Central Bank and Bank of England both on hold appeared first on AdviserVoice.