The Fed: Dovishly Hawkish
The Fed: Dovishly Hawkish
Floating rate cuts alleviates the need for rate cuts.
Discussion
Break-Evens
Over private Xwitter on Tuesday I said the Fed would be dovish this week due to the fact TIPS break-evens had moved back down into the Fed’s comfort zone. This was no brilliant insight ahead of FED Governor Christopher Waller’s very obvious pivot Wednesday - break-evens are simply the most reliable leading indicator of FED rhetoric. Like clockwork, if break-evens move materially in either direction FED rhetoric adjusts accordingly in real-time.
This was no brilliant insight ahead of FED Governor Christopher Waller’s very obvious pivot Wednesday - break-evens are simply the most reliable leading indicator of FED rhetoric. Like clockwork, if break-evens move materially in either direction FED rhetoric adjusts accordingly in real-time.
Waller is Powell
It is well-established that Waller speaks for Powell, and Powell speaks Friday ahead of the Fed’s blackout period. He will be dovish, despite the market’s perception today that Barkin was sent out to walk back some of Waller’s dovishness. Barkin’s commentary was directly in line with Waller’s, saying that he’s not fully confident inflation is on a path back to 2%. Waller said the exact same thing (see speech and Q&A notes section below).
The “Pivot”
What the Fed is trying to do here is anchor inflation expectations. They are as concerned about break-evens falling out of the bottom of a 2-2.5% range as they are about them breaking out above the range, so with 5y5y BEs falling sharply as of late, they want to ensure deflation doesn’t become a big enough concern to warrant early-than-necessary rate cuts. So, counterintuitively, floating rate cuts ultimately alleviates the need for rate cuts.
Burns Watch
As discussed at length in the SPX outlook, not only is the Fed unlikely to cut rates ahead of an election, but it’s especially unlikely to cut rates with supercore inflation well above target. However, I need to wide open to the possibility Powell is in fact Burns, because the fact the Powell Fed gets this skittish with break-evens at 2% means there is still a decent chance Powell really goes for the soft landing instead of cementing an anti-Burns legacy.
Right now the effective Fed Funds rate is 1% above YoY supercore PCE inflation.
In the infamous “stop & go” era of the Burns Fed, this measure of the real Fed Funds rate was north of 2% for a sustained period of time in 1969 and 1973. Yet, supercore inflation never fell to 2.75%, the current FED target (i.e. the pre-pandemic level it seeks to be “confident” inflation is durably on its way back to 2%).
Now, obviously there are differences in the economic backdrop today, but the fact remains: a current 1% real Fed Funds rate, only in place since May, is nowhere close to the level required to ensure inflation is durably brought back to 2%. Further, if the Fed wants to do the bare minimum on Fed Funds via “opportunistic disinflation” monetary policy, then at minimum a 1-2% real Fed Funds rate must be held for an excruciatingly long period of time.
If Powell cuts in March at the first sign of inflation being durably back at target, he is Burns full stop, and potentially even worse given Burns waited for recession to hit before engaging in the “stop” part of “stop and go”.
Equity Market Implications
The equity market implications of the Fed’s “pivot” are straightforward: with investor positioning not yet at an extreme (see exhibits below), CDXs moving down sharply, defensive sectors underperforming, bullish seasonal flows entering the market, the economy cooling, and rates moving down, there is room to run on the upside with the FED threat to markets neutralized for the time being.
I strongly suspect a series of breadth thrust signals will fire before this rally terminates, indicating a well-supported 2024 is in store for equities (as discussed in the SPX outlook), but that package of signals will likely mark the interim top in this rally before a growth scare hits markets in 1H24.
NAAIM not yet extreme.
Nor is a $SPYSTSignals’ broader measure of sentiment.
Waller Speech and Q&A Notes
Speech Notes
Opening Remarks:
Encouraged by the slowing of data, but inflation is still too high
Too early to say if the slowing in inflation will be sustained
“Increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2%.”
Still uncertainty about the pace of future activity, so not yet sure if the FOMC has done enough
Recent Data:
3.9% unemployment is as low as it got during the booming job market of the 1990s
Moderation in October CPI was broadly distributed, unlike past soft prints
Core CPI was a “modest” .20% MoM, and 3.4% 3M annualized
October PCE was likely 3% over the last 3 months and 2.5% over the last 6 months
Case for Continued Disinflation:
Real time housing data should keep housing inflation data at a moderate level
Goods prices have moderated so much that they won’t be contributing much to inflation anymore
Some moderation needed in core nonhousing services inflation to bring overall inflation down to 2%
Moderation in wage growth should help supercore moderate
Summary Conclusions:
Evidence encouraging, but not enough to ensure it will continue
Just a couple of months ago inflation and activity bounced back up
“While it is encouraging to see inflation by the FOMC’s preferred measure dipping below a 3% rate over the last three or six months, our target is still 2%. And policy needs to be set at a level that moves inflation to 2% in the medium-term.”
Implications for Monetary Policy:
Supply side problems are mostly behind us and will provide little support returning inflation to 2%. Monetary policy will have to do the rest of the work
Productivity has averaged 1.5% since the pandemic. Premature to conclude productivity growth should help guide the stance of monetary policy
Despite recent FCI easing, FCI is tighter than before the summer. But the recent easing is a reminder that policymakers should not be overly reliant on FCI to do their job
Q&A Notes
Soft landing in train save for an unforeseen shock. Recessions are always caused by a shock
Taylor Rule says that if inflation falls low enough you don’t need to keep rates elevated.
Taylor Rule says that “if we see this inflation continuing for several more months…that we feel confident that inflation is really down and on its way [to 2%] that you could then start lowering the policy rate.
If it was all a supply issue, then there should have been deflation on the way down. The fact we got disinflation means the price level adjusted upward as a result of demand.
“If 50 people go to a 15-seat restaurant and they run out of food, is that a supply issue?”