The Fed: Hiking Cycle Incomplete
Discussion
In the executive summary of the November 28 SPX outlook I said:
The problem with a soft landing attempt is the Structural Inflation Powder Keg that sits beneath the US economy: at circa 4% YoY core nonhousing services PCE inflation (i.e. “supercore”) is running well above the Fed’s 2.5-3% target, wage growth is north of 4% YoY, and the federal deficit is projected to run at 5-10% of GDP for the foreseeable future. A growth/market-friendly easing of monetary policy in 1H24 would light the fuse.
Despite consistently floating the possibility of a soft landing, the Fed has been explicit in its intention to maintain “tighter for longer” monetary policy until it is “confident” inflation is on its way durably back to 2%, defined as supercore inflation returning to its pre-pandemic level of 2.5-3%. With supercore running above 4%, the Fed guiding to rate cuts no earlier than 2H24, and the Fed by default hesitant to adjust policy so close to an election, rate cuts are highly unlikely in 2024 outside of a material recession.
Since November 28 there has been a bit of a round-trip in the market’s expectations of FED policy in 2024: OIS has gone from pricing in more than six rate cuts in the wake of Powell’s dovish December 13 press conference to less than four today as the threat of another rate hike starts to permeate the market conversation. This leaves us almost exactly where we were on November 28. Almost.
As discussed at a high level in a January 27 Xwitter post, it is my thesis that there will be no rate cuts in 2024. This thesis has only strengthened since Jan 27 in the wake of the Jan 31 FOMC, Powell’s 60 Minutes interview, post-FOMC FED communication (official and unofficial), and key economic data prints, and I believe the key question market participants need to ask themselves at this juncture is: When will the Fed resume rate hikes?
Executive Summary
Realized inflation data is second fiddle to inflation expectations when it comes to the stance of monetary policy. It is no coincidence that the Fed has reintroduced the prospect of another rate hike into the market conversation via its “unofficial” communication channels as the TIPS break-evens curve has marched steadily higher.
The Fed is looking for supercore inflation to return to its pre-pandemic average to be “confident” it can begin dialing back policy restraint with inflation durably on its way back to 2%. Not only is supercore inflation not there yet, the January CPI data suggests it is now moving in the wrong direction.
Even if the US economy is more post-WW2 1950s than it is 1970s, with a 5-10% of GDP fiscal deficit in place and TIPS break-evens precariously positioned the highly data-dependent Powell Fed is not going to allow the economy to reaccelerate without a concurrent response from monetary policy. With all signs but the inverted UST curve pointing to a US economic reacceleration, odds are exceedingly high the Fed begins hiking again in December.