Rapid Rate Cuts: Really?
Treasurys Differ From Powell in Message
Remember what Federal Reserve Chairman Jerome Powell said at his press conference on December 13. With the latest core consumer price inflation rate (which excludes food and energy) still running at an annual rate of 4% — twice the Fed’s target — Powell said in answer to a question, “We believe that we are likely at or near the, the peak rate for this cycle” [sic]. He indicated later in the Q&A session that “the question of when it will become appropriate to begin dialing back the amount of policy restraint in place . . . is clearly a discussion-topic . . . for us at our meeting today.”
With bonds and equities already rallying in anticipation of easier Fed policy, the Chairman’s message propelled risk asset prices up like a rocket ship during the final weeks of the year. The S&P 500 index closed 2023 up 24%. While the immediate aftermath of the Powell statement was positive for financial markets, I compared the impact his outlook for policy as the equivalent of pouring gasoline on fire.
Why? Let us count the number of ways.
First, while the core CPI inflation rate has fallen from its peak of 6.6% in September 2022, it is still way above the Fed’s target. History tells us that traversing the final steps to achieve the inflation goal is the hardest — and may involve curbing consumer demand so much as to cause a recession. Instead of sticking to the tightening policy, Powell decided that rate hikes that have already been implemented would suffice to lower inflation to 2%, allowing him to cut rates in the near future. There is no objective — or quantitative — way of arriving at this conclusion. Only political expediency in an election year could justify it.
Second, lower borrowing rates on consumer loans and mortgages that were a result of recent Fed decisions will stimulate consumer spending rather than curtail it. We got a related data point yesterday when jobs numbers released by the US Bureau of Labor Statistics showed that average hourly wages increased by 4.1% during the year ending December, accelerating from 4% in November. This too is inconsistent with Powell’s insistence that inflation will come down as a result of past tightening of policy.
Third, geopolitical uncertainties have risen as we enter 2024. Russia appears to have gained the upper hand in the Ukraine conflict, and this could prolong the war in the region — with implications for commodity prices, in particular, food and energy. Various mutually related conflicts raging in the Middle East, in Gaza and the Red Sea in particular, could push global energy prices sharply upward. If that happens, it will be of little help to investors if Powell declares the re-acceleration of inflation as “unexpected” and walks away, as he did when his “transitory” inflation mantra of 2021 did not work out.
Another geopolitical risk is the presidential election that Taiwan will hold next Saturday, the first of several elections around the world in 2024. If elected, Vice President William Lai, one of the candidates for the presidency, is expected to continue with the outgoing President’s policies toward China. This would heighten cross-strait relations because China considers Taiwan to be an integral part of the mainland.
Given all these risks, why would a Fed Chair not suggest a more cautious path for policy in providing forward guidance? Again, let us count the ways.
Timing is everything. The frequent modification of Powell messages just during May 2022 provides some background.
The Fed Chairman repeatedly claimed in the initial months of 2022 that inflation reduction to the 2% target after the post-covid stimulus could be achieved without a significant slowdown in the economy or a serious pickup in unemployment. At his press conference on May 4, 2022 he ruled out 75 basis point increases in the Federal Funds rate. Senators who had to reconfirm Powell bought his message of “pain-free” austerity and confirmed him for a second term on May 12. That is when the message started to change.
Just hours after the overwhelming 80 - 19 confirmation by the Senate, Powell indicated that whether or not the economy would have a soft landing “may actually depend on factors that we don’t control.” He also distanced himself from his statement at the beginning of the month — prior to Senate confirmation — that there will be no 75 basis point rate hike. So many changes in the Chairman’s expectations, just before and after his confirmation!
Speaking of timing, Secretary of the Treasury Janet Yellen gave some counsel to the Federal Reserve just hours before Powell’s über-dovish message on December 13. In a CNBC interview, Yellen suggested that “as inflation moves down, it’s in a way natural that interest rates should come down” — not too subtle a piece of advice from a former Fed Chair to the current one. Stimulus that a rate cut would give the economy in an election year would be welcome in an election year. In addition, the Secretary, who has been a distinguished economic scholar at several top Universities, must have been keenly aware that lower bond yields would reduce Uncle Sam’s debt servicing cost.
What are the likely implications of recent Fed statements? The yield on 10-year Treasurys is already up 18 basis points in the first trading week of the year as fixed income investors worry that Powell may not be able to stick to his promise of a rapid reduction in interest rates. The S&P 500 index is down 1.8% after its meteoric rise in 2023. If any of the risk factors I discussed above turns out to become reality, expect more upward pressure on mortgage rates, and lower equity prices.
Not a prescription that Janet Yellen or President Joe Biden will want in an election year!
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
January 6, 2024
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