With conditions in the US economy almost as good as it gets, markets have dialled back their expectations on the start of cuts to policy rates. They are now pricing for the ECB to start cutting eurozone rates before the US Federal Reserve. However, the Fed’s dual mandate, requiring it ensures both price stability and full employment, means it will move quickly if the goldilocks conditions in the US economy end.
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US GDP trounces expectations
The economy’s fourth-quarter growth surprised to the upside, capping an unexpectedly strong year during which job growth and diminishing inflation continuously powered consumer spending.
In the fourth quarter, gross domestic product increased at a 3.3% annualised rate, according to the preliminary estimate published this week. In all of 2023, the economy expanded by 2.5%.
Almost as good as it gets?
In a 16 January speech, Fed member Christopher J. Waller described the US economy as ‘almost as good as it gets’. Governor Waller has beena reliable barometer of sentiment within the Fed’s policymaking FOMC committee over the last couple of years. His last three speeches illustrate well how policymakers at the Fed have viewed conditions in the economy:
“Something’s Got to Give” – 18October– Either US economic activity needed to moderate, or progress on lowering inflation was going to stop.
“Something Appears to Be Giving” – 28 November – Economic data showed signs of moderating activity in the fourth quarter, inflation was still too high… but if disinflation continued, said Governor Waller, the Fed could start lowering the policy rate just because inflation’s lower, even if it were not at the Fed’s target of 2%! This dovish speech paved the way for Chair Powell’s pivot toward thinking about rate cuts at the December meeting of the FOMC.
On 16 January, in his speech “Almost as Good as It Gets… But Will It Last?”, Governor Waller joined his colleagues on FOMC in pushing back against expectations for early cuts, saying, “I see no reason to move as quickly or cut as rapidly as in the past.”
Governor Waller favours cutting rates ‘methodically and carefully’. This, he says, is consistent with the FOMC’s economic projections in December, in which the median projection was three 25 basis-point cuts in 2024. He also suggested the risks were skewed towards delaying the first cut rather than bringing it forward.
But will it last? Is this time different?
All good things come to an end, as Goldilocks found out. Economic expansions often end because engineering soft landings is a delicate operation that may involve central bankers in cutting rates before they are certain inflation has been conquered and thereby running the risk of having to stop, or worse still, reverse course.
This, as Governor Waller underlined in a Q&A session following his most recent speech, is the ‘worst mistake’ the Fed could make.
The FOMC will have to be thoroughly convinced that inflation has been slayed. The fact that this week’s GDP data showed the core personal consumption expenditures (PCE) price index rose by 2% for a second straight quarter, right in line with the Fed’s target, will not suffice.
Other Fed speakers have insisted on the need to be certain that inflation is vanquished before undertaking rate cuts. If a recession or a hard landing is the price to pay for avoiding reversing a rate cut, it’s a price policymakers will pay.
So where does that leave the FOMC?
Rate cuts are on the horizon, but we are not there yet. The FOMC meets on 28/29 January, again on 19/20 March and then in early May. In the wake of Governor Waller’s speech, markets became more receptive to the idea that expectations for a rate cut in March may be premature, dialling back the probability of a rate cut from 80% to 50%.
The dual nature of the Fed’s mandate – ensuring price stability and full employment – means any materially weak data could conceivably lead the Fed to announce that the facts have changed, and that monetary policy is calibrated to an environment that no longer prevails.
Whether such data arrives in March or April or later is perhaps less important than the fact that with the fed funds target rate currently at 5.25-5.50%, monetary policy is running at around 300bp above the neutral rate, which the Fed sees at around 2.5%. That leaves significant scope for realigning policy rates when the economic environment changes.
Our macroeconomic research team expects the first rate cut in the second quarter and for the Fed to then cut rates by 25bp at each meeting in 2024, taking the target rate down by 125bp this year.
Risk aversion more pronounced at the ECB?
The European Central Bank (ECB) this week kept borrowing costs on hold for a third successive policy meeting, leaving the deposit rate at 4%. President Christine Lagarde joined several of her colleagues in signalling a summer rate cut is ‘likely’. ECB Officials have appeared to pencil in June as the earliest juncture for monetary easing to commence.
That timetable is at odds with markets, however, which are leaning toward an initial move in April — a view the ECB has repeatedly ruled out. After the 25 January meeting, there were dovish tweaks to the view of recent growth and inflation trends in the admittedly short statement, while President Lagarde acknowledged the rise in headline inflation in December was smaller than the ECB had anticipated.
She focused on data dependence and played down the need for the ECB to see any individual data point to begin easing, perhaps raising hopes that the policy stance could shift promptly if the macroeconomic view changed.
Those dovish comments were enough for investors to raise their assessment of rate cuts coming through soon. Before the latest policy meeting, the probability of a cut by April stood at 63%, but by the close on 25 January, it was up at 93%. And a full 50bp of cuts are now priced by the June meeting.
Against that backdrop, sovereign bonds rallied significantly across the eurozone, with yields on 10-year eurozone sovereign debt falling significantly. Next week brings significant news with the publication of the flash consumer price inflation (CPI) number for January. Any surprises could have an important bearing on the timing of rate cuts.
In our view, growth in the eurozone is stagnating due to headwinds from a policy-induced tightening in financial conditions and a structural slowdown in Germany. Core and headline inflation are falling. Our macroeconomic research team expects both measures to fall to below the ECB’s 2% target in the second half of 2024. As a result, we anticipate sharp rate cuts ahead, starting in June and taking the deposit rate to 2.75% by year-end and then to below 2% in 2025.
Measures to stabilise Chinese stock markets
China’s stock market has been one of the worst performing in the world, with the Shanghai Shenzhen CSI 300 dropping by around 20% since August 2023 (see Exhibit 1). This fall is partly due to steadily deteriorating expectations of China’s growth — aggravated by underwhelming macroeconomic and fiscal stimulus.
This week, China’s authorities announced measures to bolster stock markets. This follows a dismal start to the year for Chinese stocks with Tokyo overtaking Shanghai as Asia’s biggest equity market, while India’s valuation premium over China has hit a record.
In all, some USD 6.3 trillion has been wiped from the market value of Chinese and Hong Kong stocks since the peak in 2021 (source: Bloomberg News), underscoring the challenge that Beijing faces as it seeks to arrest a decline in investor confidence.
After the CSI 300 Index fell for nine of the last 10 weeks, the authorities announced a package of measures including about 2 trillion yuan (USD 278 billion) to buy mainland shares via offshore trading links.
In addition, China’s central bank will, from February, cut the amount of reserves banks must maintain, a move that is part of efforts to boost growth. The 0.5% cut to the People’s Bank of China’s (PBoC) reserve requirement ratio, announced on 24 January, will inject RMB 1 trillion (USD 140 billion) of liquidity into the financial system.
Chinese stocks rose in response to these measures, which may help to put a floor under the market. While there can be little doubt that valuations of Chinese stocks are far lower, investors may need to see more concrete actions from Beijing to prop up growth as well as policy shifts to drive a sustained rebound in the market. Such measures could be unveiled at the annual legislative sessions in early March.