Viewpoint
February 02, 2024 | 14:22
February 2, 2024
Economics
Economics
Economics
Economics
Economics
Economics
Why an Early Fed Rate Cut Still Looks Like a Long Shot |
| Forgive me for being skeptical. The blowout employment report in January only solidifies our forecast and belief that even a May rate cut is unlikely. We are still not fully convinced (and Jay Powell and the FOMC evidently agree) that inflation is on a smooth glide path to their 2.0% target. High-frequency economic indicators continue to surprise on the upside, and we are starting to see some troubling trends emerging on the energy, transportation, and goods-pricing side that, if sustained, could stall—or even reverse—some of the great progress on headline inflation today. Given the poor track record of economic and inflation forecasts of late, the Fed is wise to remain cautious of the aggressive rate cuts currently being priced in to the forward curve based on a sanguine macroeconomic outlook. Economic and inflation uncertainty remains high and a risk management approach to monetary policy remains warranted. |
| Much of the sharp improvement in inflation over the past year has come from declining energy, transportation, and goods prices. WTI crude oil prices were on average 15.2% lower in 2023 than in 2022. While still early days, year-to-date WTI crude oil, gasoline, and heating oil futures are rising in 2024. Increasing conflict in the Middle East that targets global shipping and energy transportation makes the future course of U.S. energy prices this year all the more uncertain, placing energy as an important upside risk for consumer inflation this year. While the U.S. probably doesn’t source as much of its imported goods through the Red Sea and Suez Canal as Europe, collateral damage to U.S. shipping costs is already clearly visible even on the West Coast (Chart 1). At $4,099 per container this week, the highest level since September 2022, the container rate from China to the U.S. West Coast has jumped more than 164% since December and 244% from the July 2023 low. Even the Fed’s Global Supply Chain Pressure Index, which had shown significant slack in global supply chains over most of last year, firmed to a more neutral level by November and December. We expect to see significant further tightening in this index when the January number is released (this Tuesday). Finally, and most importantly, crude goods producer prices fell 18.9% year-on-year through December, helping keep finished goods producer prices and core goods consumer prices nearly flat over the past year. Unfortunately, the best news on goods price inflation appears to be nearing an end. January’s Manufacturing ISM revealed a huge increase in the prices paid index to 52.9 from 45.2 in December (Chart 2). This is the highest level on this measure since April of last year and the biggest monthly jump since March 2022. If the highly anticipated easing in housing and services price inflation doesn’t arrive on time this Spring, further progress on the consumer inflation front early this year could be much more challenging than the market currently expects. |
The Fed’s Painstaking Rate Cut Pivot |
| The FOMC kept the fed funds target range at 5.25%-to-5.50% on January 31, for the fourth consecutive meeting. The policy statement was altered momentously; the previous tightening bias was dropped (recall the “any additional policy firming” phrase). It was replaced by (the underlining is ours): “In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee 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 percent.” While the strong signal here is that the next Fed action will be a rate cut, the “any adjustment” mention means a possible rate hike is still not being ruled out. Although, we reckon it would take an extreme data development to trigger it, such as a major reacceleration of core inflation. More importantly, although rate cuts are coming, they won’t be happening anytime soon given the “gained greater confidence” criterion. In the press conference, Chair Powell said a March 20 move was “unlikely”. Subsequently, making it even unlikelier was January’s employment report showing strong growth in both payrolls and wages. |
| So, what will it take for the Fed to gain enough rate-cut confidence, which we’re still expecting to happen around midyear? On the ground, the performance of the PCE price index (PCEPI), the Fed’s inflation target, has been stellar (Table 1). For the total, core, and core services ex-housing (‘supercore’) metrics, the three-month moves are slower than the six-month trends, with most running around or below the 2% mark. The six-month trends are, in turn, slower than the yearly changes, pointing to further disinflation from starting points of 2.6% for total, 2.9% for core and 3.3% for core services ex-housing. Powell said: “we’re looking at a continuation of the good data that we’ve been seeing”. |
Although seeing these yearly changes south of 2½% (with cooler supercore readings across the board) could be what the Fed is waiting for, we suspect the more stubborn CPI results are a concern. The yearly changes in the CPI’s underlying inflation figures (core and supercore) are both almost 4%, noticeably above the PCEPI’s. Although CPI inflation usually runs above the PCEPI by construction, the current spreads are above the historic norms (a median of about 40 bps between the cores, for example). The discrepancies among the shorter-term measures are even greater. The CPI’s core tenors are growing above 3.2% annualized (PCEPI below 1.9%), with the supercore tenors above 4.3% annualized (PCEPI below 2.8%). For the Fed to gain greater confidence in the PCEPI’s stellar readings—the prerequisite for rate cuts—it’s probably imperative that the CPI’s readings improve materially. After next week’s annual revisions (which packed an upside surprise last year), there are three CPI reports and three PCEPI reports before the next, essentially ‘live’, FOMC meeting on May 1. That’s plenty of data to either gain greater confidence, or see it rattled. |
A Productive Year for the Economy |
| At the start of 2023, virtually no one expected real GDP to rebound 3.1% in the next four quarters after slowing to a measly 0.7% rate in the previous four. But rebound it did, and yet inflation still made a hasty retreat. That’s not supposed to happen, according to Mr. Phillips. Of course, it helped that the supply side (for both goods and labor markets) repaired itself quickly and energy prices careened lower. But an unheralded hero of both the economy’s resilience and inflation’s retreat is productivity. For nonfarm businesses, labor productivity rose 2.7% in the past four quarters after contracting in the prior year. Businesses managed to get 3.3% more output from a relatively small 0.6% increase in work hours. No doubt, part of the improvement simply reflects a bounce after productivity sagged when demand for low-skilled positions recovered during the re-openings. As well, companies were pushed to find efficiencies to address worker shortages, a force that could abate as shortages ebb. The exceptional productivity gains of the past three quarters, averaging almost 4% annualized, almost certainly won’t be sustained. Still, there’s a decent chance that labor productivity has found a new, higher groove and will at least grow around 2%. It has risen 1.6% annualized since late 2019, only a couple ticks below the pace of the prior four years. Importantly, we might be seeing some early payoff from the accelerating use of AI systems. AI could be the mother of General Purpose Technologies, in the same pantheon as electricity. Not only will it improve the efficiency of tasks in most industries, it could do so faster than other GPTs (given very little learning curve on the part of users), and by spawning new ideas and innovations. True, it threatens to displace many jobs, but it will also complement the performance of workers. While the productivity gains of AI could be spread over decades, we might be on the cusp of a new era in economic performance. Rising productivity has taken the edge off a still-tight labor market to help subdue inflation. While hourly compensation rose 5.0% in the past four quarters, the upswing in productivity limited the rise in unit labor costs to 2.3%, almost half the prior year’s pace. With revenues rising even faster, businesses no longer need to hike prices to preserve profit margins. While some further slowing in wage growth might be needed before the FOMC gains confidence in achieving its inflation target, faster productivity might be critical in achieving this outcome. Meantime, higher productivity is supporting consumer spending by both corralling inflation and lifting incomes. That’s why it’s deemed the Holy Grail of living standards. A more productive workforce tends to earn more pay. Real (inflation-adjusted) hourly compensation rose 1.8% in the past four quarters after diving in 2022 when inflation flared. This boost in spending power helped lift real personal consumption 2.6% last year, more than double the prior year’s pace, despite rising interest rates. Bottom Line: Productivity is the gift that keeps on giving and the U.S. economy just might have found its Golden Goose. While the odds of a ‘no landing’ are likely still low, another year of outperformance—for both the economy and inflation—could well be within reach if this goose keeps laying eggs. |
