The Fed delivered a ‘hawkish’ cut yesterday, signaling that a phase of recalibration of rates was effectively over. The context for this is as follows:
1. It has done 100 bps of rate cuts over a relatively short period of time.
2. The progress on inflation isn’t as consistent as it hoped for, while growth continues to run strong.
3. Fed funds rate is now closer to neutral and hence one has to be more careful going forward. Further, the incoming administration’s proposed policies inject further uncertainty and hence create greater incentive to use the flexibility to wait.
We examine each of these points in a little more detail below:
1. The rationale for cuts so far: It is widely understood that in this cycle the Fed has had to hike much beyond what would be considered as long term neutral, even in the new post pandemic context and even as the concept of neutral itself is largely theoretical. Thus, once the need was over there was understandably some keenness to reverse some of these hikes especially as, with expected inflation falling, the so-called real policy rates were automatically rising unless the nominal rates were cut to compensate. What gave further impetus to the decision was the fact that sometime during mid-year there was a rapid rise in unemployment rate. This justifiably created anxiety at the Fed and helped trigger the decision to start with a relatively hefty 50 bps of cuts. This was perfectly understandable from a risk management standpoint.
2. The progress on the dual mandate: Probably the most important takeaway from Powell’s press conference in our view was that risk to both sides of the dual mandate (inflation and employment) seem to have risen and that the Fed may have some uncomfortable choices ahead. Powell said more than once that the pace of job creation was somewhat lower than what was needed to keep the unemployment rate constant. He assessed that the labor market was still cooling and that it was somewhat looser than what it was just prior to the pandemic. Despite this, the recent emphasis that any further weakening is neither desirable nor welcome was missing. This was probably for two reasons: One, the stalled progress on inflation alongside headline economic growth being stronger than expected has shifted the balance of emphasis back towards inflation containment. Indeed, the revised economic projections clearly summarize this: real GDP growth estimate is 50 bps higher for this year versus projections made in September while PCE inflation estimate is 40 bps higher for next year. An obvious point here is that better confidence on overall growth should translate into better confidence for the labor market as well. This is reflected in Fed members projecting practically the same unemployment rate for the future as we are at currently. And yet, the characterization as described by Powell of the labor market gives no great confidence that the unemployment rate cannot creep higher from here.
3. Rising Policy Uncertainty: There is a three- fold cocktail of uncertainty now: 1> Near term neutral rate can only be deduced post facto by observation and thus is practically a useless real time guide. However, as Powell observed, they are 100 bps closer to it now. 2> The path of disinflation has turned bumpier and growth is holding strong despite labor market loosening 3> The policies of the incoming administration may entail additional inflationary pressures. The obvious backdrop to this is that the Fed, amongst some of its other peers, now puts little faith in projections given recent history and is much more driven by concurrent developments. Given that monetary policy acts with ‘long and variable lags’ this is highly suboptimal but perhaps unavoidable for now. However, what this does is inject larger uncertainty into the market given that there is no anchor but of concurrent data for both the market and the Fed.
The US Economic Disequilibrium
The Fed expresses general happiness that the economy has held up and inflation has been substantially reduced via, amongst other things, an aggressive rate hike campaign. While this is no doubt broadly true, not all is fine under the hood. For asset owners and net savers, the prognosis is indeed bright with both price appreciation and carry income running strong. However, for people at the other end of this spectrum the going is indeed quite tough. Furthermore, at current mortgage rates and prices the housing market is somewhat frozen. Additionally, with both hiring and lay-off rates coming off, the labor market also seems to be losing flexibility.
It is quite obvious then that important aspects of the economy are not in a state of sustainability, even though things are looking good at a headline level. Furthermore, the link between labor market loosening and inflation easing seems less strong, potentially throwing up tough choices for the Fed ahead. While for the time being, the Fed has reduced emphasis on the former in favor of the latter, such a state can only continue till so long as the labor market loosening remains orderly and the unemployment rate is stable at current level. Should this change then monetary easing may have to recommence even if the attainment of 2% inflation continues getting pushed back.
It is to be noted that, while the context is different, this is also consistent with an idea that we have long emphasized: the current level of US budget deficit cannot co-exist with this strong a dollar and these levels of real yields without seriously compromising future fiscal flexibility. A change to this trifecta may not happen suddenly or dramatically, but slowly with one rationale step at a time. Also, the change may not be directly linked to debt sustainability at all but this will nevertheless be a key eventual parameter.
Indeed, we couldn’t help notice the Fed chair talk of the non-market linked parts of core non-housing services. These are components whose values are imputed rather than directly collected from the market. Additionally, there are other components of inflation like rentals where the narrative is of inflation readings taking time to catch up with lower market values. Thus, should it be required to respond to further labor market weakness, the Fed may easily find the analytical confidence to do so even with the attainment of the 2% inflation target pushed well into the future.
Conclusion
The Fed outcome was decidedly hawkish and signals a new phase of policy where recalibration is over and one has to proceed more carefully going ahead. This is especially true as progress on inflation seems unsatisfactory, growth has held up stronger than expected, and the incoming administration’s proposed policies throw further uncertainty around inflation. And yet the labor market is characterized as cooling, the headline economic growth hides underlying disequilibrium, and the Fed knows no better than the market. This last point has meant that we have had multiple shifts in direction just over the past year. These shifts are only as durable as the direction of the current batch of economic data, and as data turns so will expectations all over again. The absence of any expectation anchor does, however, lead to more volatility and market unsureness. But these need to be carefully interpreted rather than be seen as a blanket ban on action; a point we have discussed in detail in our year end note recently (https://bandhanmutual.com/article/19905). This is especially relevant as India’s bond story is strong, transmission of global volatility relatively muted, and potential near term triggers are lining up.
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