The US Federal Reserve this week surprised markets by revising down its forecasts for inflation and policy rates in 2024 alongside. This pivot caught bond markets off guard and boosted the rally underway since late October. In Europe, the European Central Bank and the Bank of England did not join the party. They remained cautious, providing an eloquent illustration of the differing approaches to monetary policy on each side of the Atlantic.
Ahead of the final meeting of 2023 of the Federal Open Market Committee (FOMC) on 12-13 December, there was no doubt in the markets that policymakers would leave official rates unchanged.
It also seemed feasible, in the wake of his comments at the start of December, that Chair Jerome Powell would react to the sharp fall in US Treasury bond yields since late October and the corresponding easing in financial conditions for US economic agents. He, and his 12 (voting member) colleagues on the FOMC, could have done this by clearly ruling out any prospect of early rate cuts.
Instead, the FOMC delivered a package comprising its standard brief communique, the quarterly ‘dot plot’ or survey of FOMC members’ forecasts for the future level of official rates, and then Powell’s 45-minute press conference, which was unanimous in making it clear that the US central bank is now thinking about cuts much earlier than the market had anticipated.
In September, when the Fed last issued a ‘dot plot’ showing the future level of policy rates expected by each FOMC member, it surprised by indicating that a majority still expected to raise rates once more in 2023. Financial markets reacted by pricing US Treasury bonds to reflect a narrative of ‘higher for longer’ for US policy rates.
Team Transitory is back
This week, we learnt that FOMC members have looked at the facts and changed their minds, although it is not evident that the facts fully explain their conversion.
US Inflation data over the last three months has generally suggested that the pace of dis-inflation is slowing, and it remains at levels that appear too high for policymakers’ comfort. We do see signs of a rebalancing in the US labour market, but average hourly earnings are still rising at an annual rate of around 4%, a level not compatible with the Fed’s 2% inflation target.
It may well be that the Fed still believes the bout of post-pandemic inflation was transitory. Alternatively, the central bank may now be shifting its focus to looking through recent data and focusing on ensuring full employment, the other component in its dual mandate next to maintaining price stability.
Rate cuts on the table at the Fed
Projections for the level of longer-term rates have not changed significantly, but the FOMCS’s predictions for 2024 now suggest plans for looser monetary policy are being made.
In September, 10 members of the FOMC thought that the federal funds rate would still be above 5% by the end of 2024 (versus 5.25-5.50% currently). Today, only three still expect that. The median estimate has fallen by 50bp, and one FOMC member anticipates a fall to below 4%.
Chair Powell could have balanced this dovish signal by giving a more hawkish tone to the press conference after the meeting. He chose instead to fill the punchbowl to the brim by signalling a pivot is on the way. In this view, monetary policy is now ‘well into restrictive territory’ and not just merely ‘restrictive’ as he said in November when financial conditions were tighter.
This week’s FOMC statement no longer featured the comment made in November observing that “reducing inflation is likely to require a period of below-potential growth and some softening of labour market conditions.”
The Chair went on to say that the Fed would need to start cutting rates ‘way before’ inflation reaches its 2% target. He also pointed out that failure to do so could lead to an overshoot and slow the economy too much.
Is the Fed perhaps mindful of rising real policy rates (see Exhibit 2) caused by the fall in the Fed’s preferred inflation gauge, the core personal consumer expenditures (PCE)? The downward revisions, by 50bp, from 3.7% to 3.2% for core PCE inflation in 2023 and from 2.6% to 2.4% in 2024, were striking elements of the new FOMC forecasts.
Moreover, FOMC members revised their perception of risks to core PCE inflation to ‘broadly balanced’ now from their ‘weighted to the upside’ assessment in September.
Financial markets were bemused by the FOMC’s apparent conversion from hawks to doves. This is understandable as Chair Powell’s declaration that the Fed is now ‘very much focused’ on the risk of keeping rates too high for too long stands in stark contrast to the previous message that it might be necessary to keep them ‘higher for longer’.
The Fed Chair also acknowledged that the FOMC had discussed when they should start cutting rates before specifically going out of his way to not to take the opportunity offered by a participant at the press conference to express disquiet about the loosening in financial conditions following the roughly 80bp fall in 10-year US Treasury bond yields over the last six weeks.
Admittedly, the FOMC has kept its options open by retaining a tightening bias as well as continuing to shrink its balance sheet by selling off bonds, but the broad thrust of the message was unequivocal and bond markets reacted accordingly.
Bond yields pivot lower and risky assets rally
The fed funds futures markets reacted to the Fed’s message by repricing the path of Fed monetary policy (see Exhibit 1) and now expects roughly six cuts of 25bp each across the eight FOMC meetings scheduled for 2024. The market even sees a 20% probability of a rate cut from the Fed in January 2024.
The yield on the 2-year US Treasury note touched a six-month low at 4.28%, down almost a full percentage point from the 17-year highs it hit in the second half of October, before recovering to 4.36%. There was a sharp fall in the yield of the 10-year US Treasury bond. After almost topping 5% in the wake of the September FOMC meeting, its yield fell to below 4%, strongly implying that the peak for this cycle is behind us.
Valuations of risk assets rallied with the S&P500 equity index making a new 2023 high. Perhaps the most important illustration of the nature of this rally is its breadth. After a narrowly based advance in US stocks focused a few giant tech companies through October, the gains have broadened to cover the full range of sectors in the S&P index.
A dry December for the ECB and BoE
The European Central Bank (ECB) and Bank of England (BoE) declined the opportunity to declare victory over inflation at their policy meetings on 14 December. Their caution, relative to the Fed’s message on the previous day, damped the market rally.
Christine Lagarde, ECB president, warned that there was ’work to be done’ before inflation fell to its 2% target, while Andrew Bailey, BoE governor, said there was ‘still some way to go’ in the UK.
Both the ECB and BoE held their policy rates steady, the ECB at 4% and the BoE at 5.25%, with Lagarde cautioning “we should absolutely not lower our guard” against consumer price pressures.
The ECB maintained its benchmark deposit rate at its highest-ever level of 4% for the second consecutive meeting. ECB policymakers repeated their determination to keep borrowing costs at ‘sufficiently restrictive levels for as long as necessary’.
The eurozone’s central bank forecast consumer price growth would slow to its 2% target within the next three years — clearing a key hurdle for it to consider cutting rates. But Lagarde said policymakers would be ‘a little bit more severe’ and aim to hit that milestone by 2025 (see Exhibit 3).
Our interpretation of the ECB’s stance is that it prefers a cautious approach to the risks of acting prematurely. Policymakers did not discuss cuts, still see upside risks to inflation and plan to keep policy rates higher for longer.
There are, in our view, growing risks of a disconnect between the ECB’s policy stance and the data. The risk being that ECB policy may have to pivot more abruptly if inflation continues to fall at the pace seen this autumn. A discussion about rate cuts could start in January with an actual rate cut in March not to be excluded.