Fed Speak – Chris Waller still sees no hurry to cut rates

1 Apr 2024 , 09:35 AM

WHAT CHRIS WALLER SAID LAST TIME AROUND?

The last time Fed Governor Chris Waller spoke, he had surprised the market by saying that the Fed had no reason to hurry into a rate cut. His reasons were fairly convincing too./ Waller’s contention was that while inflation had fallen from the highs, it had been in a very tight range of about 30-40 bps in the last few months. That only underlines the long-held perspective of the Fed that the last mile would be the toughest in inflation control. He had offered a broader explanation last time, that sticky inflation did not justify a rate cut, but robust growth did not call for a rate cut. In short, there was no hurry to cut rates.

Nearly a couple of months later, Chris Waller appears to be  holding on to the same view. His speech at the Economic Club of New York had a clear message, “There is still no rush to cut rates.” He still holds on to the view that inflation is much higher than warranted and the high levels of GDP growth, labour market strength and the consumer spending were not in consonance with 2% inflation target. Hence the strategy of holding rates higher for longer would be a good idea at this juncture. Ironically this view comes just a couple of weeks back when Jerome Powell, in his Fed statement almost hinted at 3 rate cuts in 2024.

WALLER IS RIGHT: DATA DOES NOT SUPPORT RATE CUTS

Even as the markets were expecting some cues on rate cuts in the March Fed meeting of the Federal Reserve, Jerome Powell in his post-polity speech did  hint that 3 rate cuts would happen in 2024, even if back-ended. However, data flows in March have not been too supportive of this kind of approach, Here is why.

• Let us talk about the consumer inflation in the US first, which is announced around the middle of the month. For February 2024, the consumer inflation in the US was up 10 bps at 3.3%. This comes on top of the fact that last month the consumer inflation had come in at 3.2%, which was 30 bps higher than the street expectation. The pressure came from energy prices, even as food and core inflation had tapered in the month.
• A similar trend was also noted in the PCE inflation announced by the US BEA on the last working day of the month. Even the PCE inflation inched up by 10 bps to 2.50%, which is a full 50 bps now above the target inflation of 2%. With the last mile inflation challenge being the toughest, energy prices remain the key risk factor for PCE inflation.
• Let us finally turn to the third and final estimate of Q4-2023 GDP that came in 20 bps higher at 3.4%, compared to the second estimate at 3.2%. This reinforces the full year growth at 2.5%, a good 150 bps above the expectations on the street. Such robust growth and jobs levels are out of sync with 2% inflation that the Fed is targeting.

Waller is of the view that the Fed should be waiting and watching the incoming data, instead of trying to give guidance on interest rates. With sticky inflation above the target, West Asian geopolitics volatile and a robust GDP reading; Waller feels there is no incentive or even necessity for the Fed to cut rates at this juncture.

CHRIS WALLER THINKS THERE IS STILL NO RUSH TO CUT RATES?

Like in his speech a couple of months back, Governor Christopher Waller underscored that the Fed was in no rush to cut rates. Remember, this comes after Jerome Powell had hinted at 3 rate cuts happening in 2024. Here are some specific reasons offered by Waller for his perception on why the Fed could actually wait on rate cuts.

• According to Waller, recent data flows have raised a big question mark about the continued progress towards 2% inflation. For instance, the Q4-2023 GDP final estimate has come in 20 bps higher at 3.40%, even as the jobs data and the inflation number are much hotter than expected. According to Waller, after this recent performance, the Fed should wait for more confirmation that the signals of inflation easing in the second half of 2023 were actually genuine.
• Waller has also pointed to other data points to substantiate that the pace of growth of the US economy was not in sync with 2% inflation, which could not happen if the pace of growth of the economy was too frenetic. For instance, February 2024 job gains had moved back up to the level of 275,000, pulling up the 3 month average to a higher plane. Even the core personal consumption expenditures (PCE) inflation jumped to 0.4% MOM in January 2024 after averaging as low as 0.1% in between October and December 2023. The MOM is a strong lead indicator of long term inflation.
• Waller was also worried about the pace of growth in consumer inflation in the US, which was eventually reflected in the PCE inflation with a lag. According to Waller, the pressure on inflation came from the energy basket, and that is one area the US economy does not have much control over. The export market is still controlled largely by the OPEC Plus grouping and, despite being the largest producer in the world, the US still relies to a large extent on import of crude oil.
• While Waller does not rule out rate cuts in 2024, his strong view is that the Fed must gradually start preparing the markets about fewer rate cuts. Originally, the Fed had hinted at 3 rate cuts in 2024 and 4 rate cuts in 2025. In the last policy statement, the Fed had cut the outlook for 2025 just 3 rate cuts. However, it may have to tone down the expectations on 2024 rate cuts also. Interestingly, the CME Fedwatch has already done that by assigning a probability of 50% to just 2 rate cuts in 2024.
• Waller puts the current dilemma of the Fed in perspective and also offers the solution. According to Waller, FOMC must wait for further progress on inflation and not get carried by the market enthusiasts. For now, the strength of the US economy and resilience of the US labour market imply that the risk of waiting a little longer to ease policy is fairly small. The risk is also significantly lower than acting too soon and possibly squandering the progress that the Fed has made so far on the inflation front.
• In the US, while the US Bureau of Economic Analysis (BEA) offers 3 estimates of GDP for the quarter just elapsed. However, the Atlanta Fed GDPNow model focuses on the coming quarter. For Q2-2024, the Atlanta Fed is projecting GDP growth of 2.1%. While this is slower than 4% in H2-2023, there are 2 factors. The 2.1% GDP growth is still too high to justify 2% inflation target. Secondly, even in 2023, it was eventually that the economy surprised on the upside with its resilience. Hence, caution was warranted.
• Consumer spending was expected to slow with higher rates. Initially, the consumer spending showed a lot of resilience due to labour shortfalls sustaining higher wages for a long time. This largely offset the impact of rate hikes on consumer spending. However, an interest trend is now emerging, despite the moderation in consumer spending. There is a perceptible moderation in goods spending in the second half of 2023. However, consumer spending on services like energy grew moderately and offset some of the slowdown in consumer goods spending. Even on the business side, while the manufacturing business is under pressure, that is largely being compensated by robust growth in the non-manufacturing business.
• Waller has also suggested that the actual labour data may be much stronger than the 3.9% unemployment rate indicated. For instance, The share of unemployed went up in recent months due to the influx of a number of young people in the age group of 16 to 24 years. However, youth employment tends to be volatile, so this rate could drop back in the next few months and pull the overall unemployment rate back down to the 3.5%. On wages, while they have tapered in recent months, it is well above pandemic levels.

Clearly, as Waller has pointed out, it may be still too early to get down to an enthusiastic round of rate cuts. Caution may be the word here. However, there is one interesting trend that is emerging; the US productivity levels has spiked in recent quarters.

YES, US PRODUCTIVITY IS GETTING BETTER BY THE DAY

According to Waller, one of the silent reasons that could explain the surge in GDP in the US amidst a plethora of headwinds is the rise in productivity in the US. It may be a long-term factor, but it is happening for sure. According to Waller, when productivity across the economy grows quickly, output and income grow quickly without putting upward pressure on inflation. As a result, it quietly raises living standards. According to macro estimates, US productivity has growth at around 4% in the last 3 quarters of 2023; a pace that is much faster than the average productivity growth since the 1970s. The last time the US had seen sustained growth in productivity was between 1998 and 2004. Is that really a factor?

Waller is sceptical about this argument and feels that the dynamics of productivity may be more about short term factors and less about long term factors. For instance, productivity grew in the last 3 quarters of 2023; but had actually contracted from the start of 2022 to the first quarter of 2023. So, if you average the productivity growth across the last 2 years, it would be closer to 1.25% and nowhere close to 4% that is being spoken about. According to Waller, productivity gains in the US could be due to large investment projects in the US, lower inflation and artificial intelligence boosting productive. However, the impact of such factors may be felt more in the long run, than in the very short run.

Waller feels that, more than productivity gains, the recent robustness in GDP growth and consumer spending may have more to do with the supply chain constraints getting addressed post the pandemic and supply lines getting back to normal. Also, post-pandemic production models have been making people more productive, but again this could be a short term outcome, which may not last too long. Hence, productivity may be a fact, but it really does not explain much of the output gains in recent times.

FEW SWALLOWS DO NOT A SUMMER MAKE

Waller feels it would be premature to act based on just two months of data, especially when the Fed has the luxury of waiting. Especially, with the growth story so robust and steady. The recent Fed dot plot and the update on long term projections indicate that members of the FOMC are not giving undue weightage to the recent data. The bigger challenge is to convince the market that inflation control and a strong labour market; rather than rate cuts are the end that the FOMC is working towards. Hence, each FOMC meeting must not end up with the only question of how many rate cuts in 2024? It was data driven and, as Waller says, it will continue to be data driven.

In his speech, Christopher Waller has outlined two axioms. Firstly, the risk of waiting a little longer to cut rates is significantly lower than acting too soon. Secondly, cutting the policy rate too soon and risking a sustained rebound in inflation is best avoided. In terms of strategy, Waller holds on the to the view that the Fed has the luxury to wait and watch and that is exactly what it should do now. There should, at least, be a couple months of better inflation data before even conceiving rate cuts; so that the US economy remains on the path to 2% inflation on a sustainable basis. The overall strength of the US economy makes it a fairly easy decision. Policy easing can wait.