Stephen Miller

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, in a nod to meaningfully lower inflation, the Fed also abandoned guidance that kept future policy rate increases on the table in favour of more neutral guidance providing flexibility to lower the policy rate in the coming months if it is convinced inflation hazards have receded. In its Statement the Fed noted that “the risks to achieving its employment and inflation goals are moving into better balance,” and further, that changes to the economic outlook could prompt “adjustments” to the target range. That contrasts with prospect of “additional policy firming” that officials had maintained since last lifting rates six months ago.

At the same time the Fed signalled the shift in its outlook shouldn’t imply a rate cut is imminent stating that it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 per cent”.

In his press conference Fed Chair Powell reinforced the push-back, describing a policy rate cut in March as “unlikely”. He did note that it “will likely be appropriate to begin dialling back policy restraint at some point this year,” but added the rider that “progress toward our 2 per cent inflation objective is not assured.”

That implies perhaps some marginal shift in the Fed’s thinking back in December when the Fed’s median “dot plot” projected a policy rate of 4.6 per cent by end-2024. That was some distance from above the close to 4 per cent that the bond market had been projecting prior to the release of that Fed decision.

In large measure that gulf in expectations has persisted into 2024 and judging by Chair Powell’s comments overnight is likely to persist for a time yet.

This is despite signs of clear “over-achievement” (relative to forecast) on core private consumption expenditures (PCE) deflator – the Fed’s preferred inflation measure. That measure came in at 2.9 per cent over the year to December while the 3-month annualised rate of growth (the inflation ‘pulse’) grew at just 1.5 per cent. The 3-month annualised rate for the Dallas Fed trimmed-mean measure was at 2.3 per cent. This compares with a target of around 2 per cent and forecasts for 2023 and 2024 at 3.2 per cent and 2.4 per cent respectively.

The source of the Fed’s reticence to publicly embrace rate cuts of the order of magnitude priced by the bond market is that there has also been “over-achievement” on activity growth. Real gross domestic product (GDP) grew by 3.1 per cent over the year to the December quarter compared with the 2.6 per cent forecast by the Fed as recently as December.

The progress on inflation to date notwithstanding, the firm activity backdrop may have contributed to some lingering anxiety at the Fed regarding the sustainability of that progress. The process of disinflation tends is frequently a disjointed one: a process of “two steps forward and one step back” with the “last mile” to the inflation target proving particularly challenging.

I have spoken in the past of key global structural elements at work that will make that “last mile” even more daunting. The globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating; globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of “industrial policy” and “national champions”; domestic regulation of goods and labour markets is increasing in scope (leading to upward price pressures); and baby boomer workforce participation is declining (limiting labour supply and lifting wages).

Admittedly these currents haven’t prevented meaningful declines in inflation over the latter half of 2023, including as mentioned, the “over-achievement on the Fed’s favoured measure. However, the recent December consumer price index (CPI) print in the US – where the core measure surprised on the upside – is a reminder of the pitfalls of too readily embracing any emergent narrative that the process of disinflation will be smooth.

There are risks that go the other way. The bond market might be correct in terms of its expectation of aggressive rate cuts is if a recession were to eventuate (not that I believe the recession narrative is driving bond market rate cut expectations). For example, last year’s unexpected resilience might have been the result of a US fiscal “sugar hit” as the budget deficit approached an unprecedented 7 per cent of GDP, even as the economy hovered around full employment. In the almost certain event of a withdrawal of that fiscal support (unless there are even more discretionary additions to the budget deficit), the ongoing impact of the monetary tightening in 2022 and 2023 might need to be more rapidly withdrawn than the Fed currently contemplates, resulting in more aggressive policy rate cuts.

What might be asserted with some confidence is that having largely (if not completely) seen off the inflation threat, the prevailing levels of the policy rate and bond yields opens the way for the Fed to respond to a downdraft in growth, enabling bonds to potentially re-assume their sometime role as a mitigant to risk-averse sentiment.

Yes, there may be challenges around the “last mile” to the inflation target, but they are arguably symmetric with (perhaps even less likely than) downside risks associated with a sharper than anticipated slowdown. At currently prevailing yields it is not a stretch to posit that bonds offer investors a modestly attractive yield without the prospect of significant capital losses.

But absent a crisis leading to a downdraft in growth, it seems clear that the Fed may once again test the faith of markets in terms of the Fed’s appetite to deliver rate cuts of the order of magnitude currently implied by the bond market.

By Stephen Miller, investment strategist 

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