As at January 24, 2024

Author: Gavyn Davies, Executive Chairman

Main Points:

• In this week’s Chairman’s Views, I have chosen to circulate the economic material that was presented to the Fulcrum Investment Committee at this week’s meeting. Please find the presentation below.
• Markets have shifted slightly away from a soft-landing scenario for the US and global economies since extreme optimism was recorded at the Federal Open Market Committee (FOMC) meeting on 13 December. In retrospect, the dovish language used by Chairman Powell at that meeting represented “peak Fed dovishness”, at least for now. Since then, there has been a small increase in US and global interest rates across the bond curves, and a rebound in the dollar. However, the US equity market has not yet been affected, and credit spreads have remained at their recent lows.
• These market shifts have partly been a response to overbought positions in the “Fed dovish” trades late last year. However, they have also had some fundamental underpinning from incoming economic data. The US economy has continued to grow at or slightly above trend, and incoming labour market data has remained very firm. Meanwhile, the surprising decline in core inflation seen in the second half of 2023 may be stabilising. While these developments are operating only at the margin, they appear to have had some effect on Fed guidance about near term monetary policy.
• Fed Governor Christopher Waller once again captured the mood last week with a mild push back against early and large rate cuts. His statement that the Fed was in “no rush” to ease monetary policy was the key phrase of the week. It was reflected in sentiments expressed in the central banking community throughout the advanced economies.
• A repeating theme from FOMC speeches has been continued or even increased confidence that core inflation will soon fulfil the stated criterion required for policy rate cuts to begin. But this confidence has been matched by clear warnings that the Fed cannot risk needing to reverse course once rate cuts have started – FOMC members Daly, Williams, Bostic, Logan and others have repeated this language very clearly. They have also repeated their support for the three policy rate cuts shown in the FOMC’s median forecast in December. My reading is that they have been a tad less dovish than Powell implied at that meeting, especially about the timing of the first rate cut.
• There has been no clear message in recent FOMC speeches about whether financial conditions indices (FCIs) had now eased too much, given the flow of incoming economic news. Lorie Logan specifically warned about the easing in the FCI, while Christopher Waller clearly denied that it is a concern. This divided view contrasts with the widespread agreement that the FCIs were becoming too tight in October. For risk markets, the relative lack of concern about the latest easing in the FCIs is good news, since it limits the likelihood of a very hostile Fed for now.
• Several FOMC members have mentioned or hinted that an easing in the labour market is needed to indicate that lower that inflation will not rise again. This rising saliency for labour market conditions is due both to the persistence of strong payroll numbers and low initial claims and also to worries that the supply side gains in the labour market seen during 2023 may be coming to an end.
• The decline in labour supply is driven by a fall-back in prime age labour participation rates and may be accentuated by a likely drop in immigration flows under policies reportedly agreed to by President Biden as part of the package required by the House of Representatives to keep the government open in January.
• In addition, disruptions to shipping in the Suez and Panama Canals have caused some tightening in supply chains in global goods supply. While this has been very modest so far, it is clearly working in the wrong direction compared to last year.
• The FOMC’s thinking on these matters is summarised in this excerpt from the Wall Street Journal:

“Fed policymakers are considering the question of how much more supply the economy has to offer. Several “assessed that healing in supply chains and labor supply was largely complete, and therefore that continued progress in reducing inflation may need to come mainly from further softening in product and labor demand,” according to minutes of their December policy meeting. (A few officials assessed there is still room for additional supply gains.)”

• There is also a lot of focus on upcoming inflation numbers, including the wedge between the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index. We are not very concerned by the wedge since it mainly reflects the different treatment of shelter in the two indices. As shelter inflation falls further this year, the CPI inflation rate is likely to fall faster than the PCE inflation rate with both approaching target through the year.
• Fulcrum inflation models indicate that the 6-month annualised PCE inflation rate will stabilise at or slightly above 2% for much of this year. This means that the headline 12-month core PCE inflation rate – the Fed’s main target – will be close to the 2% target by the year end.
• Given this inflation forecast, a soft landing in the US remains very probable. We now attach a 60% subjective probability to this outcome, down from 65% before.
• We increase the probability of “no landing” from 20% to 25% which means that the probability of a hard landing remains at 15%. (These probabilities as usual refer to changes in market perceptions in the coming 3-6 months, not the eventual outcome for 2024)
• A March policy cut by the Fed seems somewhat unlikely unless inflation falls further, and the labour market eases compared to recent months. We do not expect definitive Fed guidance about the March meeting at the end of the January FOMC, but the statement may delete the bias towards tightening that has been in place for two years. This would imply that May or June would be highly probable start dates for rate cuts.
• The market now expects five 25bp policy rate cuts this year, compared to six cuts two weeks ago and compared to three cuts in the FOMC median dots. In coming weeks, it would be surprising to see the market pricing in more than five cuts for the year, or less than four, provided that the soft-landing scenario remains intact.