04 Jan 2024
2024 The Year that Defines Jay Powell’s Legacy
Markets were encouraged by the December US Federal Reserve meeting as the dovish comments of the Fed Chair came across as a pivot on interest rate policy. Some commentators were surprised at this tone, given the loosening of financial conditions, which declines in longer-term interest rates have delivered. In 2024 Powell will need to prioritise between looking to nail a soft landing and a legacy of one of the great US central bankers to deliver this, with the ongoing risk that the Fed loosens too early. If this occurs, he will go down in history as another Arthur Burns and runs the risk of engineering a recession if he is then forced to tighten monetary policy again at a later stage.
At the meeting, Chair Powell stated that inflation had eased from its highs and that this had occurred without a significant increase in unemployment. In fact, for the unemployment rate to stay virtually constant when interest rates have been raised to 525bp is unprecedented. The Fed still believe that inflation, despite ongoing progress, remains too high. The Fed emphasised once again that restoring price stability, which is inflation in line with its 2% goal, is a priority. Interest rate policy is now restrictive, meaning that there is downward pressure on economic activity from the level of rates. With the normal lags in monetary policy, the full effects of this tightening would not yet have been felt, and in the post-pandemic world, it seems that the transmission mechanism is slower than in previous cycles. The market focused on a change in wording where the Fed added the word ‘any’ to the phrase that they would make ‘decisions about the extent of ANY additional policy firming’. The market took this as a definitive sign that the Fed believe that rates have peaked. After very strong GDP growth in the third quarter, it seems apparent that economic activity has slowed, which should be unsurprising in the light of not just higher interest rates, but the run down in post-pandemic savings. Fulcrum ‘Nowcast’ estimates that GDP in the fourth quarter was initially showing signs of coming in at around the 1.5% level, a sharp slowdown from the previous quarter, but the most recent employment and retail sales data suggest an eventual outcome of around 2% on their models, in line with the Atlanta Fed. Economic growth for the year as a whole is likely to be around 2.5%, well in excess of expectations at the start of the year. Fed Committee participants expect growth to fall to around this level or slightly below in 2024, although the most recent data suggests that the US economy will enter 2024 still growing above trend and this reduces the chance of rate cuts in Q1. In this scenario, if the employment market stays strong, what need is there for the Fed to cut rates early?
The labour market has seen slightly softer conditions with the three-month average of non-farm payroll gains averaging just over 200,000. Unemployment is likely to come in at around 3.7% at the end of 2023 and strong job creation has been accompanied by an increase in the supply of workers as the labour force participation rate has moved up, particularly for individuals in the 25 to 54-year age bracket. The Fed expect the unemployment rate to rise to just 4.1% by the end of 2024 which would indeed be a soft landing if it occurred.
The Fed continue to believe that inflation will take time to get down to the 2% level for the core PCE – falling to 2.4% in 2024 and not reaching 2% until 2026. However, the degree of policy tightness implied by the Taylor rule, which Fed Chair Powell is believed to use to judge policy tightness, shows the current level of the Fed Funds rate to be very restrictive and allows the Fed to cut rates next year, even though inflation in the short term remains above target. The Fed has clearly been influenced by the sharp drop in core PCE inflation over the last couple of months and Chair Powell admitted that the CPI data, published on the first day of the meeting, and the PPI data published on the second, prompted adjustment by Fed members to the published SEP (Summary of Economic Projections) at the eleventh hour.
The December meeting saw FOMC participants write down the individual projections which were the views of the individuals at that moment rather than a consensus which has been debated by the committee. Projections are that the Fed Fund’s rate will be 4.6% at the end of 2024, 3.6% at the end of 2025, and 2.9% at the end of 2026, still above the median longer-term rate.
During the following press conference, Powell reaffirmed that by adding the word ‘any’, there was an acknowledgement that the Fed believe that ‘we are likely at or near the peak rate for this cycle’. Chair Powell acknowledged that the next key debate for the Fed will be when to dial back the amount of policy restraint in the economy, or in other words when to start cutting rates.
Early in 2023, Powell had talked at press conferences about ‘navigating by the stars under cloudy skies’. During the latest meeting he was asked what the surprises had been over the past year and whether there was more clarity looking forward. Powell acknowledged that most forecasters had expected very weak growth or a recession in 2023 and that the Fed were surprised by the strength of the US economy which has benefitted not just from strong demand but real gains on the supply side as labour force participation picked up, together with immigration. This has helped unwind the shortages and bottlenecks that have come from the pandemic.
The Fed had forecast a significant increase in unemployment a year ago in its SEP which has not happened, and the Fed is encouraged that the labour market is coming back into balance despite there being more job openings than available workers at present.
If the Fed wish to maintain the same level of restrictive policy as inflation falls, there is scope for at least a modest easing of interest rates. Powell stated that, despite a Presidential election next November, the Fed were not frontloading rate cuts as they haven’t taken political events into account, and they will continue to act in a way in which they feel is right for the economy at the time. Powell did state at the meeting that, while inflation was moving in the right direction, it was not yet at the 2% mark and of course if the economy did not slow as expected, it would take longer for inflation to hit its target, meaning that rates would stay higher for longer than the market expected and that a rate hike might be needed again. However, the overall tone of the meeting suggested that the Fed views this as an outlier possibility. Chair Powell also outlined that, while he was pleased to see workers getting wage increases, current levels of around 4% are still a bit above what is considered compatible with a 2% inflation rate.
The Fed expect the labour market to remain reasonably strong without a significant increase in unemployment, but Powell added that they are conscious of making the mistake of easing policy too late if unemployment levels rose. He added that, while the Fed had been forced to focus hard on the price stability part of its mandate, it was now getting to the point where both mandates (inflation and full employment) were important. The SEP aggregate forecast of 75bp of rate cuts in 2024 in the most part reflects the fall in inflation rather than significant reductions in real interest rates. The market forecast of rate cuts is based on the Fed reducing the level of restrictiveness in monetary policy in 2024.
Powell commented that while many people were suggesting the neutral rate of interest had risen, this is likely to be something that would still be debated in a decade’s time, so in effect pushed back on the idea that the neutral rate would need to be higher in the post-pandemic and Ukraine world. Powell also stated that QT would continue at a similar rate to 2023, allowing run off each month.
In the same week as the Fed meeting, both ECB and Bank of England comments were more guarded with regards to early rate cuts. The ECB acknowledge that rates have probably peaked but remain concerned about wages and unit labour costs. The Bank of England is concerned about persistent inflationary pressures and in fact three of the nine-person committee wanted to raise rates at the last meeting.
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