Fed statement says, inflation still too high for rate cuts

1 Feb 2024 , 09:28 AM

Fed refuses to commit on time table for rate cuts

There was an old saying in the British Monarchy that when the market tries to battle the crown, it is normally the crown that wins. That does not mean that the crown is right and the market is wrong. It just goes to show who calls the shots, when push comes to shove. That is exactly what is playing out in the US markets. The CME Fedwatch, which is a market representation of Fed rate cut expectations has been a little too optimistic. When the Fed announced the likelihood of 3 rate cuts in 2024 and 4 rate cuts in 2025, the CME Fedwatch went virtually berserk. It pegged that the Fed would front-end all the seven rate cuts in 2024 itself and lower rates by 150 to 175 bps by the end of 2024. That is looking increasingly dim.

Between the last Fed minutes and the speeches by the Fed governors, the CME Fedwatch had already cut its expectations from 150-175 bps rate cut to a more sober level of 100-125 bps. However, even that is looking increasingly in doubt. The Fed has been harping on the need to bring down inflation in previous interactions. To be fair, the PCE inflation (Fed benchmark) has come down to 2.6%; just 60 bps short of the Fed target. However, while food inflation and core inflation have tapered, it is fuel inflation that stays sticky. With the aggravation of the Red Sea crisis, the Fed does not want to take any chances with the inflation reading. It would rather wait for inflation to decisively move to 2% mark. The Fed believes that the last mile from 2.6% to 2.0% inflation could be tougher than expected.

Five interesting takeaways from the January 2024 Fed statement

Clearly, the Dow and NASDAQ were far from impressed by the cautious tone of the Fed statement. The benchmark S&P 500 was down -1.61%. Here are 5 key things that stood out about the Fed statement issued by Jerome Powell on January 31, 2024.

1. Fed chair, Jerome Powell make it clear that the Federal Reserve had a price stability mandate and now a growth mandate. Reacting to the strong GDP data for Q4, Powell said that Fed was not concerned even if the economy was overly strong. Hence, growth or not growth, inflation would continue to be the guiding principle for the US Fed.

    

2. Powell has expressed his view that there was no need to upset the applecart, when things were moving fine on their own. For instance, in the last 2 years, the inflation has come down without any sharp increases in unemployment or slowing growth. When the existing approach was working, Fed saw no reason to change course tactically.

    

3. Fed underlined that they had a mandate for maximum employment and price stability. However, the Fed was still looking for signals that inflation was on a clear path downwards; and that the path was sustainable. Hence, the upcoming inflation data would be the key determinant of how the Fed moves on rate cuts.

    

4. Fed is watching the inflation reading combined with consumer confidence. According to Jerome Powell, despite low unemployment, the consumer confidence has only just started to improve. That is linked to inflation expectations. Hence, the Fed would also use revival in consumer confidence as a proxy for lower inflation expectations.

    

5. In terms of projections, the Fed has already indicated that rate cuts in the upcoming March meeting also looked very unlikely. Fed expects the Red Sea crisis overhang to still be there for some time. It now looks like the Fed may explore the possibility of rate cuts either in June 2024 or after that; something markets had not bargained for.

Overall, there is a sense of disappointing in the markets. Not only has the Fed remained cagey about a rate cut time table, it has continued to insist on more evidence on falling inflation. What is working for the Fed is that the economy is quite strong and most doomsday economists have continued to get their growth projections awfully wrong.

CME Fedwatch remains optimistic of rate cuts; but only just

One way to look at the Fed outlook from a market perspective is the CME Fedwatch, which captures probabilities of rate levels after each Fed meet over next 1 year. One big question after the minutes is; is whether the CME Fedwatch is just being too optimistic.

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Mar-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	53.0%	47.0%
May-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	47.3%	47.6%	5.0%
Jun-24	Nil	Nil	Nil	Nil	Nil	5.5%	47.4%	42.7%	4.4%	Nil
Jul-24	Nil	Nil	Nil	Nil	5.2%	45.3%	42.9%	6.3%	0.2%	Nil
Sep-24	Nil	Nil	Nil	5.2%	45.3%	42.9%	6.3%	0.2%	Nil	Nil
Nov-24	Nil	Nil	3.0%	28.5%	43.9%	21.7%	2.8%	0.1%	Nil	Nil
Dec-24	Nil	2.6%	24.4%	41.4%	25.2%	5.8%	0.5%	Nil	Nil	Nil

Data source: CME Fedwatch

The CME Fedwatch has only marginally toned down its expectations of rate cuts and continues to expect 100-125 bps rate cut by December 2024. It is nowhere close to the enthusiasm of last month when the Fed was expecting 150-175 bps of rate cuts in 2024. However, the CME Fedwatch continues to assign a 50% probability to a rate cuts in March 2024, although the Fed has virtually ruled it out. However, first decisive rate cuts that the CME Fedwatch is betting on is in May 2024, with most rate cuts concentrated in H2.

It is not that the Fed is less or more aggressive. The Fed has just a lot more cautious and refuses to be drawn into any time table. If you look at the story from the Fed perspective, today they have the luxury to be cautious. Inflation has dropped sharply since 2022 and GDP growth is still robust even as unemployment remains in control. The Fed has achieved lower inflation without disrupting jobs and without forcing a hard landing on the American people. Since the Fed can afford to be cautious for longer, the dichotomy between the CME Fedwatch and the Fed stance is likely to continue for now.

What we read from the minutes of the Jan-24 Fed statement

For now, the Fed has refused to commit itself to any rate view or time table for rate cuts. Here is what we read from the Fed statement, issued by Jerome Powell after the meeting of the Federal Open Markets Committee (FOMC).

1. Fed Chairman Jerome Powell has underlined that the central bank would not be comfortable with the path of inflation by the time of its next meeting in March, to warrant a rate cut. That virtually rules out a rate cut even in the March meeting, although the CME Fedwatch continues to assign a 50% probability to a March cut.

    

2. In the January Fed meeting, the FOMC was unanimous about the need to keep rates static at the current level of 5.25%-5.50%. It looks like the ongoing Red Sea crisis may have induced the Fed to maintain the stance of higher for longer. Powell only indicated that rate cuts would commence, sometime during the year 2024.

    

3. However, the Fed statement did contain enough hints that further rate hikes were off the table for now. Clearly, the Fed wants to avoid being enticed by the elegance of data flows. Back in late 2021 and 2022, the Fed had anticipated that inflation would be transitory, but was shocked by the persistence. It does not want to decide in a hurry.

    

4. For now, the Fed is only talking about the commencement of rate cuts. With March ruled out, the rate cuts may start in May or (more likely) in June 2024. However, Powell has underlined that once the rate cuts have been initiated, further rate cuts and the speed would largely be contingent on the data inflows.

    

5. According to the Fed, there would only be one more PCE inflation data point before the March Fed meeting, which may not be sufficient to assess the impact on inflation. However, the Fed would have 3 PCE inflation data points by the May Fed meeting, which makes it more credible for them to draw conclusions on the trajectory and pace.

    

6. Explaining its reluctance to commit on rate cuts, the Fed has underlined that consumer confidence surveys continue to paint a bleak picture, despite record low unemployment. This is indicative that the low consumer confidence can be attributed to higher inflation expectations and that is what is making the Fed cagey at this point of time.

    

7. Talking on the sharp fall in inflation since 2022, Powell underlined that it was not just the tight monetary policy, but other factors like the normalization of supply chains and the healing of the labour markets that also helped bring inflation down rapidly. In short, it is the combination of supply chain and labour markets that made this cycle different.

    

8. Powell has refused to commit that the US economy has achieved a soft landing. He feels that a better description would be an economy that has cooled without being tipped into a recession. However, Powell still feels it is too early to pat themselves in the back as the Q4 GDP indications are only early indicators and full data is yet to stream in.

    

9. Commenting on the subject of 3 rate cuts in 2024, Powell underlined that that was the median estimate of the dot plot of the members of the FOMC. However, that was always subject to the condition that the members were agreeable that inflation was decisively trending lower. That consensus was still not there.

    

10. On the specific inflation data, Powell has commented that most of the inflation moderation has happened in goods and not in services. The service inflation continues to be high and that is the stickier part of the inflation story. Hence, the Fed would need irrefutable evidence that services inflation was also decisively coming down.

     

11. However, the one positive takeaway is that Powell has almost confirmed that the rate hike cycle was done and dusted and that the policy rates were at the peak of the tightening cycle. However, Powell also underlined that just because rate hikes had peaked; did not automatically presuppose that rate cuts will start immediately.

     

12. One thing Powell has clarified is that Fed cannot be expected to lower interest rates in an effort to reduce the frenzy of an anticipation around a March move. In short, the market indicators are supposed to react to the Fed indications and not the other way round. That is a clear message to the strong believers in the wisdom of CME Fedwatch.

 

To sum up, a rate cut in March may still not be off the table, but with just one PCE inflation data point, it looks unlikely. The real Fed action may start in May or June this year. 

What does the January 2024 Fed statement mean for the RBI?

RBI effected its last rate hike in February and kept rates static in its subsequent 5 meetings in April, June, August, October, and December 2023. For the RBI, consumer inflation is structurally under control. For the Indian economy, what does away with immediate risks to inflation is that the core inflation is sharply lower than it was a few months back. GDP numbers have been robust in Q1 and Q2; and the Q3 numbers on February 28, 2024 will hold the key to the full year trend. Clearly, growth is not the worry!

With RBI holding status quo on repo rates since February 2023, it is almost fait accompli that rate hikes are done. The January Fed statement is unlikely to change that stance. What the RBI would focus on is on the Fed minutes and the dot plot; and not so much on the Fed statement. RBI would also be looking at the Fed for rate cut indications and would prefer to align its move to avoid monetary divergence. For now, the RBI is likely to keep its eyes focused on growth and consumption; rather than worry about inflation trajectory.