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.
Analysis
Inflation Expectations
Buried in a February 5 essay FRB Minneapolis President Neel Kashkari’s carefully worded emphasis of the critical importance monetary policy has played in keeping inflation expectations anchored revealed the Fed’s true focus of current monetary policy:
If supply-side factors appear to be contributing meaningfully to disinflation, what role has monetary policy played and how is it affecting the economy now? Monetary policy has played an enormously important role in keeping long-run inflation expectations anchored. It is hard to overstate how important that is for ultimately achieving the soft landing we are all aiming for. But to assess what impact policy is having on inflation going forward, we must first try to determine how tight monetary policy actually is.
In answering his own question about the role monetary policy has played in bringing down inflation, Kashkari immediately pointed to inflation expectations and then quickly emphasized the point with “it is hard to overstate…”.
Back in November I wrote about how the TIPS break-evens curve influences FED messaging in real-time, and how at that point the well-anchored state of the curve suggested the Fed had room to be dovish. I certainly did not anticipate the Fed becoming as aggressively dovish as it did in November/December, as it had been a matter of weeks since they had endorsed the market-based tightening of financial conditions as a substitute for more rate hikes; but with the entire curve anchored at the 9/30/2021 pre-tightening cycle level, it’s now obvious they did not want a de-anchoring of break-evens to the downside driven by excessively hawkish messaging.
But now they have the opposite problem: break-evens are marching steadily higher and at serious risk of parabolic upside de-anchoring. All it would take is a series of upside surprises in some combination of inflation, wage, and employment data, and/or a continued rise in oil and gasoline prices for this de-anchoring to occur. It is NOT an accident that key “unofficial” FED messengers Roger Ferguson and Larry Summers have explicitly engineered the threat of another rate hike back into the market conversation.
Supercore Inflation
Not only is the TIPS break-evens curve threatening to force the Fed to more seriously entertain a resumption of rate hikes (i.e. beyond threatening more hikes through “unofficial” channels), but supercore inflation (i.e. core nonhousing services inflation) is still well above the pre-pandemic average the Fed is looking for to be “confident” it can dial back policy restraint with inflation durably on its way back to 2%. The PCE measure of supercore inflation is closing in on the pre-pandemic average (3.34% versus 2.71% as of the YoY December reading), but CPI remains well above at 4.29% versus 2.25% as of the YoY January reading (the January PCE reading will come out later this month) and is now moving higher, a reacceleration confirmed by the spike in ISM Services Prices Paid data.
Economic Reacceleration
Lastly, against the very long odds presented by a now years-long inversion of the UST curve, the US economy looks to be in the process of reaccelerating.
I noted in real time during his January 31 press conference that I could not believe Powell said the Fed’s anecdotal business contacts were suggesting the economy was picking up at the margin. If one is looking for the Fed to be “confident” enough to start cutting, a pick-up in the economy is precisely the opposite of what one would want to see. In the weeks leading up to January 31 my process had picked up on the notably bullish macro message emanating from within the equity market (Transports vs. Utilities, Banks vs. Utilities, Discretionary vs. Staples), I was just surprised to see Powell formally acknowledge the pick-up given the Fed is supposedly so focused on deciding when to cut rates.
FRB Atlanta President Raphael Bostic expanded on Powell’s comments just last week in a February 15 essay (my emphasis):
…the gist of the story we hear from contacts is that, despite moderating activity, businesses are not distressed. Rather, many are sitting on pause, awaiting the optimal time to deploy assets and resume hiring to expand their operations. To me, this carries the ring of expectant optimism—perhaps even pent-up exuberance—with the potential to unleash a burst of new demand that could reverse the progress we have observed toward rebalancing supply and demand across the economy. In my view, this constitutes a new upside risk to my outlook that bears scrutiny in coming months.
While there is certainly a case to be made the US economy today is more akin to the post-WW2 1950s than the 1970s (as evidenced by the significant disinflation seen to-date without a concurrent pick-up in unemployment), and thus able to reaccelerate without igniting a second wave of inflation, with the TIPS break-evens curve on the cusp of breaking out and the Federal government running a 5-10% of GDP fiscal deficit, the highly data-dependent Powell Fed is not going to allow a reacceleration to occur without a response from monetary policy.
With the equity market continuing to point to upside economic risk and credit markets wide open, odds are exceedingly high the Fed will resume rate hikes after Election Day (barring, of course, an out-sized tightening of broader financial conditions in the interim, which would allow the Fed to cut rates without risking a second wave of inflation). This set-up makes the December 2024 OIS contract (437 Fed Funds) one of the most mispriced contracts in financial markets today, roughly 121 bps below where it’s likely to end up.