Fed Speak – Bowman highlights risks to the Fed monetary stance

30 Sep 2024 , 10:48 AM

FED SPEAK – MICHELLE BOWMAN CAUTIOUS ON RATES

When the Fed announced its monetary policy statement on September 18, 2024, it had cut the rates by a full  50 bps. Another interesting thing that marked the policy statement was that Michelle Bowman became the first Fed governor in 19 years to offer a dissent vote. Bowman had said that should would prefer a 25 bps rate cut instead of a 50 bps rate cut for two reasons. According to Bowman, the 50 bps rate cut sent out two erroneous signals to the market. The first signal was that the Fed appeared to be declaring victory over inflation through a 50 bps rate cut. However, the prospects of rising energy inflation was still a potent problem, considering the strife in the Middle East. Also, the last mile inflation was yet unresolved and that is, normally, the most complicated. Add to that, the best of tapering core inflation was done and in the last 2 months the core inflation was up by 30 bps.

The second wrong signal that the 50 bps rate cut sent out, according to Michelle Bowman, was that the situation on the growth front was desperate. Normally, a 50 bps rate cut is undertaken either in the midst of a crisis like the COVID pandemic or the global financial crisis. Alternatively,  the only message was that there were serious risks to growth. According to Bowman, neither of these arguments are correct since the hard landing concerns were largely predicated on the unemployment data, which was more an outcome of the steady rise in immigrants into the job market, making jobs look artificially scarce. In the latest Fed Speak series, we cover Michelle Bowman’s presentation on the latest Monetary Policy and the Economic Outlook. The presentation was delivered by Governor Michelle Bowman at the Kentucky Bankers Association Annual Convention, Virginia.

BOWMAN’S QUICK THOUGHTS ON THE SEP-24 MONETARY POLICY

For more than 2 years (starting March 2022), the Federal Open Markets Committee (FOMC) had steadily increased the interest rates in the US and had held at the current level of 5.25%-5.50% since July 2023. However, in the light of the recent unemployment figure spiking to 4.2%-4.3%, and the PCE inflation settling at 2.5%, the Fed thought the time was apposite for a rate cut. However, what surprised the street was the intensity of the rate cut at 50 bps instead of 25 bps, as was expected. This takes the rates now to the range of 4.75%-5.00%. As stated earlier, Michelle Bowman gave a dissent vote for the first time since 2005, suggesting that 25 bps rate would have been sufficient. Bowman, for long, has been an avowed hawk in the FOMC.

Broadly, in her statement, Michelle Bowman had agreed with the Committee’s assessment that. The FOMC was of the view that in the light of the progress made since the middle of 2023 on both lowering inflation and cooling the labour market, the timing was appropriate to start the process of moving toward a more neutral stance of policy. The objection of Michelle Bowman was not to the rate cut, per se, but to the extent of the rate cut. She had openly said during the FOMC meeting that her dissent vote was purely to underline the point that 25 bps rate cut would have been sufficient considering the present circumstances. According to Bowman, a 25 bps rate cut would have send out the right message to the markets, rather than giving an impression that inflation had been tamed and growth was a major challenge. A 25 bps cut would have served the purpose of recalibration without raking up either of these perception risks in the market.

HOW MICHELLE BOWMAN SEES THE MACROECONOMIC OUTLOOK?

As stated earlier, the concerns expressed by Michelle Bowman were not so much about the decision to cut rates but about the extent of rate cuts. Here is how she had assessed the macroeconomic situation in the US at the current juncture.

• Recent months have seen considerable progress on inflation control and price stability. According to Bowman, inflation had been steadily falling since September 2022 and that had been largely an outcome of the tightness created by higher interest rates. As a result, the Fed’s preferred metrics of PCE (personal consumption expenditure) based inflation had steadily come down to around 2.5%. More importantly, the PCE inflation had averaged around 2.58% in the last 9 months, which speaks a lot about the sustainable fall in the level of inflation.
• Bowman also pointed out that recent months had seen a rapid fall in core inflation, which is the inflation excluding the food and fuel basket. It is considered to be the stickier aspect of inflation and that had come down even below the PCE headline inflation on several occasions. However, Bowman pointed out that in the last 2 months, core inflation had shown a tendency to harden and it was already 30 bps higher. This could be an indication that the COVID related supply chain constraints had sobered and so expecting further lowering of core inflation from here would be too ambitious. Bowman also pointed out that despite nearly 2 years of efforts, the PCE headline inflation and the PCE core inflation stayed well above the Fed target of 2%. The Fed would have to constantly look at core and headline inflation in this context.
• Let us now turn to the growth indicators. GDP growth in 2023 and 2024 has been distinctly stronger than in 2022. However, 2024 could not really sustain the momentum of 2023. However, it must also be said that the GDP growth had been pressured more by volatile items like exports, even as Private domestic final purchases (PDFP) growth continued to be robust. Specifically, retail sales have shown further robust gains in July and August. However, she has also sounded a cautionary note. While personal consumption stayed resilient, the trend is that customers are pulling back on discretionary items and expenses. But, the real risk is that the low and moderate income consumers, today, no longer have extra savings and loan delinquency rates are also up.
• Finally, here is a look at unemployment, which was one of the triggers for the aggressive rate cut. The unemployment rate edged down to 4.2% in August from 4.3% in July; but still much higher than last year, and sharply above the level of 3.5%, which the Fed defines as the level of full employment. One of the intent of persistent rate cuts was that the labour market had to be loosened from the very tight conditions were labour was scarce and wages were going through the roof. That trend appears to have been stemmed. The ratio of job vacancies to unemployed workers has fallen further to below historically elevated pre-pandemic level; hinting at a better and saner balance between number of available workers and number of available jobs. However, one concern that Michelle Bowman did highlight in the speech is that, despite slowing wage growth, it remained indicative of a tight labour market. Wage growth at 4% today may be lower than in 2022, but it has to come down further to be consonant with 2% inflation.

On the subject of unemployment rate, Bowman has cautioned that one has to take the jobs data with a pinch of salt. Here is why. Even today, layoffs are very low and it is just that employers are going slow on hiring. With the rise of AI and ML related jobs, there is also a skill mismatch between demand and supply, which can be bridged by training, but would take time. That is why Bowman believes that directly correlating growth with the level of unemployment may not exactly be a linear relationship.

WHY BOWMAN PREFERRED 25 BPS CUT OVER 50 BPS

While presenting her dissenting vote, Michelle Bowman was categorical that the 50 bps rate cut was not in sync with the larger goal of bringing down inflation to 2%. Here are some of the key arguments that she offered as part of her presentation.

• Michelle Bowman has stated this before in her dissent note and she reiterated the view at the presentation that reducing the target range for the federal funds rate by 50 bps could be interpreted as a signal that the FOMC sees growth fragility and a sharp downside risk to the economy. However, Bowman pointed out that there was no visible evidence of such a weakening in growth, with the lates Q2-2024 final GDP estimate coming in at a robust 3.0%, while even the first quarter GDP growth was upped from 1.4% to 1.6%. Hence, Bowman felt that a 25 bps rate cut would have better reinforced the strength in economic conditions, while also confidently recognizing progress toward price stability goals.
• According to Bowman, starting off the rate cut program with 50 bps raises expectations in the market. That is already evident in the CME Fedwatch probabilities. Now, the market participants are likely to expect a repeat in the coming FOMC meetings in November and December also. If this expectation materializes, she feels that there could be an unwarranted fall in longer-term interest rates and financial conditions could become too accommodative. That could put the 2% inflation target of the Fed at risk.
• The third interesting and significant point that Michelle Bowman highlights is the risk of magnifying a fall in bond yields. Here is how. For instance, there is still considerable pent-up demand and cash on the sidelines ready to be deployed if interest rates are to move down steadily, as that would result in capital gains for bond trades. However, such pent-up demand has downside risks. Cutting policy rates rapidly entails the risk of unleashing that pent-up demand and that demand could pull up bond prices and speed up the fall in bond yields. That is a big risk that the Fed has to contend with.

Let us finally look at what all this means for the outlook on the US macros.

INFLATION, NOT LABOUR, IS THE REAL CHALLENGE

Bowman has reiterated, as she has done time and again, that the real risk to the US economy could stem from inflation rather than from the rising joblessness or the risks of a hard landing. According to Michelle Bowman, the risks evidenced in the labour market may have been overstated for a number of reasons. For instance, a quick survey of job creators is indicative of the fact that while hiring is calibrated, there are hardly any plans for mass lay-offs. There is no real scare in the labour market and the skilled labour market is likely to remain undersupplied, at least till the cross training and the fluid mobility across roles happen. While labour has cooled in recent times, the situation is nowhere close to a labour market crisis as it is being generally made out to be in the market.

According to Bowman, it would be naïve to announce victory over inflation, because the Fed was nowhere close to that. That is because the risks to inflation are still quite prominent and elevated too. Global supply chains continue to be susceptible to labour related factors as well as to the rising geopolitical tensions. With some of the key shipping routes impacted by the war in the Red Sea, it could easily translate into inflationary effects on food, energy, and other commodities. Expansionary fiscal spending could be another factor and the recent spike in the US budget deficit in August is just one example. Also, the housing demand in the US has been quiet for too long and if that market picks up, then inflation is bound to rise. One must not forget that despite all the efforts, core inflation remains above 2.5%, so the goal of low and stable inflation of 2% is still some time away. These twin factors should have, ideally, coaxed the Fed to calibrate a 25 bps rate cut, instead of a 50 bps rate cut.

WHAT RECENT DEVELOPMENTS MEAN FOR INDIA?

It would be interesting to assess how the recent spate of events like the Fed cutting rates by 50 bps and the dissent vote by Michelle Bowman would impact the RBI take on interest rates. Surprisingly, the RBI has been silent on the subject and would, probably, prefer to make its stance clear when the RBI policy meeting concludes in early October 2024. For the RBI, there would be several considerations. It must be noted that two members of the MPC viz, Ashima Goyal and Jayanth Varma have completed their terms; and both were in favour of a 25 bps rate cut. Unlike in the US, the inflation story in India is largely clouded by food inflation, which accounts for nearly 45% of the overall inflation basket.

The question before the RBI is whether October 2024 MPC meet will be one more status quo meeting or whether the RBI MPC would go ahead and give a signal to the Indian markets by cutting rates by 25 bps. In fact, a 25 bps rate cut could be like hitting many birds with one stone. Firstly, it does away with the risk of monetary divergence that is implicit in not doing anything. Secondly, it also comes as a face saver for the Indian corporates ahead of its upcoming Q2 quarterly results wherein interests costs are likely to prove a drag. This will give them a story for their shareholders. Lastly, RBI would be giving a dovish signal to the market, without really risking a spike in consumer inflation. A lot will depend on the deliberations of the MPC, but a 25 bps rate cut cannot be ruled out by the RBI in October 2024.