Fed Speak – Governor Chris Waller bats for front-loading rate cuts

10 Sep 2024 , 01:04 PM

CHRIS WALLER SUGGESTS FRONT LOADING OF RATE CUTS

In the last few weeks, since Powell spoke at the Jackson Hole, there has been a shift in the undertone of the US monetary policy debate. It has shifted from whether the Fed will cut rates to how rapidly the Fed will cut rates. Powell himself has been a votary of a more calibrated approach to cutting the rates based on data inflows. However, a recent speech delivered by Governor Christopher Waller at the University of Notre Dame, Indiana has presented a slightly more aggressive view. According to Waller, the time is ripe for rate cuts and this time around the Fed should front-end rate cuts and be more aggressive.

There is an interesting background to this debate. Back in late 2021, Waller had been one of the persons in the FOMC to call from front ending of rate hikes to control inflation. At that point, inflation was surging but the Fed had refrained from hiking rates. The argument of the Fed, back then, was that the inflation was an outcome of supply chain imbalances and hence that would automatically rectify once these supply chain constraints resolved. However, back then, the inflation had continued to be sticky and the Fed had continued to wait. Eventually, the Fed embarked upon rate cuts only in March 2022. Many experts have argued that the Fed erred in delaying rate cuts for too long and had they started rate cuts earlier, the inflation would have been tamed much earlier. However, that is still a hypothetical argument and economic policy is based on real numbers.

DEBATE IS NOW ABOUT INTENSITY OF RATE CUTS

It is in this light that the recent speech delivered by Christopher Waller assumes significance. Just to rewind, the Fed core focus has always been on ensuring price stability and in ensuring full employment. However, both are also closely related to one another. For instance, in the post COVID scenario, there was a major shortage of labour, so labour became a scarce commodity. Hence wages were persistently rising in the US. Now this posed a major challenge for the Fed. Rising wages means that monetary policy tightening did not have too much of an impact. Even through the monetary conditions tightened, the spike in wages ensured that the purchasing power was not dented. Hence consumption remained robust and that really kept inflation higher for much longer.

Waller has mentioned that now, the balance has shifted in favour of unemployment. For instance, inflation is largely in control with PCE inflation at 2.5% and consumer inflation at 2.9% and likely to fall to 2.6% in the August reading. Hence the focus now has to shift to the employment side of the story. In the July data, the unemployment ratio had gone up to 4.3% while in the August reading it is down by just 10 bps to 4.2%. However, the absolute numbers of unemployed remains almost the same. In the US, full employment is defined as 3.5% unemployment and that is what the Fed will not strive to get close to. For that to happen; the Fed may have to cut rates more aggressively, so that growth gets a boost and the jobless ratio goes down further. The debate is now about intensity of rate cuts.

WHY THE TIME IS RIPE FOR RATE CUTS?

In his speech delivered at the University of Notre Dame, Christopher Waller presented some really cogent arguments on why the time was ripe for the Fed to embark on rate cuts.

• According to Waller, the persistent progress that the Fed had made on the inflation control front had made long strides. Hence, the balance of risks had clearly shifted toward the employment side of our dual mandate. The underlying message is that the monetary policy now needs to change its approach and focus accordingly.
• Waller has underlined that the employment report for July and August (the latest report) had come in exceptionally soft. In fact, the job creation had slowed and the unemployment rate had increased to a level of 4.3% by July, the highest level since October 2021. Despite the unemployment ratio falling to 4.2% in August, the absolute numbers of unemployed remain the same, which means the labour data is still soft.
• Waller also pointed out that over the last 30 months, the focus of the Fed monetary policy had just been on two factors viz. low inflation with stability, and full employment. Growth was never the subject, which is why the Fed had not succumbed to the temptation to cut rates in the midst of the banking crisis in early 2023. Waller feels there are other ways to handle growth, but now the time is ripe for a rate cut.
• Contrary to popular apprehensions, Waller also underlined that a spike in unemployment cannot be directly interpreted as a sign of hard landing. Just to conclude that the economy was in recession looking at the jobs data and the inverted yield curve would be an incomplete approach. While inflation had made progress, the price to pay for the same was looser labour data. Now, according to Waller, the time is ripe to rectify that balance and reduce rates to bring the unemployment rate down further.

That brings us to the very crucial question; can the GDP growth and improvement in the employment ratio co-exist with 2% inflation target? Actually, it can!

INFLATION CAN COEXIST WITH GDP AND EMPLOYMENT DATA

While the three going together looks difficult, Waller is confident that such a progress in the economy is perfectly possible. Here is why.

• There is substantial evidence to corporate that economic activity (GDP growth) is continuing at a solid pace. Real gross domestic product (GDP) grew at 2.2% annual rate in the first half of this year. The second estimate of GDP growth for the second quarter has been upgraded by 20 bps from 2.8% to 3.0%; with the first estimate already doubling from the Q1 levels. Also, the Atlanta Fed GDP estimate of Q3 GDP shows that 2.2% GDP growth on a real basis should be sustainable.
• In a consumption driven economy like the US, an important barometer of growth is the consumption and its impact on retail sales. Recent numbers have shown that households continue to spend as their finances remain healthy overall. The increase was fairly broad based across different categories of goods. Also, a recent survey of larger, non-manufacturing sector was consistent with a modest expansion of activity.
• According to Waller, one concern could be the non-farm payrolls report, especially the revisions of the previous month numbers. Payrolls rose by 142,000 in August compared with 89,000 in July. However, June and July saw a heavy downgrade of the payroll numbers and there are concerns of a similar downgrade to August also. In the short run, the jobs may struggle to absorb the labour force. The average non-farm additions have been falling sharply over previous quarters.

In short, it is perfectly possible that the US economy continues to grow GDP in tandem with falling inflation and moderating unemployment, closer to full unemployment level of 3.5%.

DO NOT READ TOO MUCH INTO RECESSION ARGUMENTS

In the last few weeks, there have been attempts to draw direct correlation between higher unemployment and a recession. However, Waller has cautioned that such relationships may not always be that straightforward. Firstly, on the inverted yield curve, Waller is of the view that the yield curve stayed negative for most part of the last one year, but growth continued at a robust pace especially in Q3 and Q4 of 2023. Secondly, Waller has underlined that such rules are more a statistical description of past economic outcomes and may not have too much of predictive value. Waller also added that on the subject of yield curve, the argument had validity when there was a major economic shock, as in the early eighties. At other times, the inverted yield curve is more of a market pricing aberration.

On the linkage between the unemployment rate and recession, Waller has added that most recession rules focus too much on demand-driven recessions. But that is not what is driving unemployment in the first place. For instance, recent data on unemployment suggests that demand is fairly strong. Instead, most of the increase in the unemployment rate is from workers entering the labour force and not finding jobs right away. In short, the problems are more of supply side problems than demand side problems. On a lighter note, Waller has also added that it was time to rethink some of the macro models and relationships in the post-COVID scenario. In many cases it has let do mistaken forecasts.

FIRST RATE CUT WILL NOT BE THE LAST CUT

Waller put it rather eloquently when he said that the first cut would not be the last cut; implying that the markets can look forward to a series of rate cuts from here. However, he has not commented on the intensity of the rate cuts. For rate cuts to continue for a longer time, the precondition is that the rate cuts do not feed inflation. Waller believes that the risk of rate cut cuts fuelling inflation is almost negligible at this juncture. That is because, with the labour market cooling, the wage growth has slowed to a pace consistent with the FOMC’s price-stability goal. That means, the risks to inflation are fairly limited. Even the employment cost index grew at an annualized rate of 3.5% from March to June, while the 12-month change was 3.9% for private sector workers. This is the lowest level since October 2021. Wage increases have also normalized, ruling out any wage driven inflation risks.

The real story of falling inflation is available in the PCE inflation reading, a measure that even the Fed favours for its rate decisions. In fact, the PCE inflation has averaged just about 2.58% in the last 9 months, giving enough indications that it had stabilized. Even core PCE inflation, excluding the volatile food and energy prices, has increased 2.7% in the last 12 months. Also, shorter period inflation averages are falling to below 2%, indicating that the trend is clearly and decisively down. A better picture is available if one looks at the components of the inflation basket to understand the breadth of disinflation.

Currently, nearly half of the categories in the total and core market baskets have annualized monthly inflation of less than 2.5% in the latest reading. The index of core goods prices has already reverted to its historical pattern of slight deflation, which is also reflective of the fact that the supply disruptions post the pandemic were largely resolved and the impact of technology was also factored in adequately. More importantly, the sticky services price inflation has also moderated considerably as wage growth has slowed. What does all this mean for the outlook for monetary policy?

It is apparent, according to Waller, that the time is ripe for rate cuts. With the inflation under control and the labour market also cooling, the time is ripe for starting the process of unwinding the series of rate hikes over the last 30 months. Waller also believes that, with inflation and employment close to the longer-run goals, a series of reduction in rates should be on the cards. There is enough slack in the economy to ensure that rates can be cut without fanning inflation.

WHAT WOULD BE THE PACE OF RATE CUTS FROM HERE?

That is obviously not something that is too clear at this point of time, but as Waller mentioned earlier, there will now be a series of rate cuts. CME Fedwatch, which represents market expectations, has pegged rate cuts of 100 bps by end of 2024 and total rate cuts of 225 to 250 bps by the end of December 2025. However, these are market expectations and as we have seen in the past, they often tend to stretch on the side of euphoria. Having said that, determining the appropriate pace at which to reduce policy restrictiveness will be challenging. It is a sort of trade off. Choosing a slower pace of rate cuts gives time to gradually assess whether the neutral rate has in fact risen. However, this also carries the risk that moving too slowly may put the labour market and even GDP growth at risk. On the other hand, cutting policy rates at a faster pace means a greater likelihood of achieving a soft landing of the US economy. However, it also runs the risk of overshooting on rate cuts and fuel unnecessary concomitant inflation. It will have to be a delicate choice.

The only thing that is clear at this juncture is that the rate cuts will start on September 18, 2024. Probably, one can also state with some degree of confidence that there would be a series of rate cuts in this cycle. According to Waller; if the data supports cuts at consecutive meetings, then that should be the road ahead. However, FOMC members like Waller have traditionally been in favour of frontloading the rate action once the data is supportive and the decision is taken. It remains to be seen whether the Fed eventually opts for a series of small rate cuts or, instead, opts to front-end rate cuts with higher intensity. Either ways, the more important message is that the Fed must be also read with a Plan-B in place should either of these approaches backfire. As of now, the gains of embarking on rate cuts and persisting with intensity are much more than the associated risks. However, a clear picture will only emerge when Jerome Powell makes the Fed statement on September 18, 2024.