Home Economy Fed probably won't raise rates as no cut is punishment enough

Fed probably won't raise rates as no cut is punishment enough

by SuperiorInvest

The market rethinks where the Federal Reserve is headed

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Is it crazy to say that the US Federal Reserve could raise interest rates this cycle? Put another way, am I willing to call Larry Summers bananas?

In an interview with Bloomberg last week, the economist said that due to persistent inflation pressures, there was a “significant” chance – he put the odds at about 15 percent – that the Federal Reserve's next move on rates could be an increase. “The worst thing you can do when your doctor prescribes antibiotics is to finish part of the treatment, feel better, and stop taking the antibiotics,” he said.

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It's not just about Summers, either. Bloomberg continued the interview with an important article: markets are beginning to speculate whether the Federal Reserve's next move will be bullish and not bearish. Mark Nash, who manages the absolute return macro fund at Jupiter Asset Management, told Bloomberg that he put the odds at 20 percent.

(A note on the 15 percent odds: That's the same chance an NFL kicker has of missing a 37-yard field goal, but also the odds The New York Times put on Donald Trump winning the election 2016.)

Summers' argument comes on the heels of a big market rethink about where rates are going. In early January, the futures market was pricing in six quarter-point cuts. These market expectations were always at odds with the Federal Reserve's own forecasts, but traders were betting on a rapid slowdown in inflation this year, as we saw in the back. half of 2023.

Since January, the macro picture has changed a bit. Inflation is falling more slowly than expected and the labor market appears strong. This adds to clear signals from Federal Reserve Chairman Jay Powell that the central bank would take its time before making cuts. Rate traders therefore controlled their expectations. Today, three to four cuts are included, starting in June instead of March:

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Market expectations are now much more in line with the thinking of the Federal Reserve itself. The central bank's December projections showed the average official forecasting three cuts in 2024, a view Powell reiterated at the bank's January meeting, and then again in a February interview on CBS's 60 Minutes.

Combining the somewhat more inflationary economic outlook with the trend in market expectations about rates, does it make sense to start betting on the possibility of an increase? I do not think.

Start with Summers' argument. He mainly cited the consumer price index (CPI) figures for January, which were positive. Headline inflation cooled less than expected, leaving the year-on-year rate at 3.1 percent. Core inflation remained stagnant at 3.9 percent. Summers particularly focused on supercore (non-accommodation services) and owners' equivalent rent (OER), which rose an annualized seven percent in January.

While admitting it was just one month of data, Summers said the CPI figures could also mark a “mini paradigm shift.” But that seems far-fetched, or at least too early to say. On the day it happened, Financial Times journalist Ethan Lu explained why we should take the data with a grain of salt: Inflation expectations look calm, the REA jump looks like noise, and January inflation data tends to be unstable. It is reasonable to think that February's numbers will be a little colder.

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Yes, the stock and bond markets took the inflation data wrong. But that speaks less to the data itself than to the amount of disinflation and optimism about rate cuts priced into the markets. Data from Bank of America Corp. shows that the disconnect between market expectations and the Fed has only been this wide in times of previous crises (March 2020, the Silicon Valley Bank mini-crisis) or during policy twists monetary.

There are no signs from the Federal Reserve that it expects to raise interest rates this year. Minutes from the Federal Reserve's January meeting, released on Feb. 21, showed officials were “closely alert” to inflation risks and cautious about cutting interest rates too quickly.

Buoyant stock and credit markets add to the Fed's caution: “Several participants mentioned the risk that financial conditions were or could become less restrictive than appropriate, which could add an undue boost to aggregate demand and causing progress on inflation to stagnate.” But despite all these reservations, the Federal Reserve is still only talking about rate cuts.

“The odds of a full increase are difficult, because the Fed would have to see a significant reacceleration in core inflation momentum,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. It is important to note that the Federal Reserve can only influence certain types of inflation. Any reacceleration would likely have to occur in core inflation (i.e., excluding higher energy prices) and would have to reflect excessively strong demand. Problems in the supply chain may not count.

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And even in the event of a reacceleration in core inflation, the Federal Reserve may not raise rates.

Markets are so committed to cuts this year that not implementing them would be “toxic,” Goldberg said. A dramatic revaluation could be achieved: collapsing stock markets, widening corporate credit spreads, and much tighter financial conditions. This would do much of the work of the Federal Reserve.

“Simply keeping rates at 5.5 percent (currently), the Fed would be making a considerable adjustment,” Goldberg said.

This is the strongest point against raises: why would you need them?

To renew the tightening, we would probably have to see the US labor market heat up further. The labor market's trend toward a better balance between supply and demand, which Powell has touted at every recent meeting, would probably have to not only stop, but reverse. This would change the Fed's calculus. Instead of facing bilateral risks to his dual mandate, the risk of higher unemployment would begin to appear diminished. As in 2022, the anti-inflation mode would come into force.

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Is thinking about rate hikes this year crazy? No, it is a real tail risk. But Summers' 15 percent probability seems too high to me. It is premature to talk about “mini paradigm shifts.” Markets are pricing tail risk more realistically: a 6.3 percent chance of a quarter-point rate hike in 2024, closer to getting a false positive on a drug test than failing a 37-yard field goal.

© 2024 The Financial Times Ltd.

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