Headed into the final FOMC meeting of 2023, a few observers were anxious about Jerome Powell’s tendency to abide market rallies irrespective of the implications for macroeconomic variables.
Powell, critics argue, is insufficiently strident, a disposition that was on full display in November, when he tacitly countenanced a cross-asset gallop that some worry could work at cross-purposes with the “last mile” of the inflation fight.
“Markets’ affinity for rate cuts loosens financial conditions and heightens the Fed’s concerns about inflationary pressures, thereby delaying the rate cuts that the markets are betting on,” Mohamed El-Erian wrote, in a December 7 Op-Ed for the FT. He noted that Goldman’s financial conditions index notched one of its most pronounced monthly easing impulses on record in November, a dynamic I discussed again and again.
Regular readers will recall the figure above, which shows how Goldman’s gauge tracked the term premium repricing closely since July, tightening as the term premium stormed into positive territory and easing as it receded.
Admittedly, the optics around financial conditions which, on some measures, are as easy now as they were in March of 2022, aren’t great to the extent that suggests the Fed isn’t doing everything in its power to ensure inflation doesn’t continue to percolate across the economy.
As of December 1, the Chicago Fed’s adjusted national financial conditions index was the easiest since the week of February 25, 2022.
Positive values on the gauge are associated with tighter conditions versus what the macro backdrop would suggest and negative values with looser.
“Powell has a proclivity to allow market optimism to run [and] when he has any cautionary or hawkish comments, they are inserted as boilerplate that lack conviction,” JonesTrading’s Mike O’Rourke said. “Powell repeatedly asserts that financial conditions are restrictive but ignores most Wall Street measures of financial conditions which contradict his view.”
O’Rourke, like El-Erian, cited Goldman’s gauge. Consider this: If you exclude the chaotic weeks around the onset of the pandemic, the bank’s measure never made it back to levels seen in January of 2016, the month after Janet Yellen braved the first rate hike since the financial crisis. (At the time, markets were still reeling from China’s August 2015 yuan devaluation.) As O’Rourke put it, “despite the historic pace of rate increases [Goldman’s index] has not surpassed the tightening levels reached when the Fed funds rate was 0.375%.”
The above helps to contextualize the December Fed meeting — to “place it,” so to speak, within the still-running equity rally and a bond surge which, at the local lows, found 10-year US yields ~90bps below October’s intraday cycle highs.
It’s important to note that the Fed’s job isn’t to defend key levels on any gauges of financial conditions. It’s certainly true that the vaunted “wealth effect” from higher asset prices can help sustain consumer spending, but I’ve argued recently that those concerns probably merit less attention now than they did in 2022. Either the disinflation process is established such that price growth is on a sustainable path back near target or it isn’t. I’m (more than) open to the idea that it isn’t, and that the Fed will thereby need to go back to the drawing board. My only point is that whether we’re looking at SPX 3900 or SPX 4600 on December 31 isn’t going to be the deciding factor.
Importantly (and some regular readers may be tired of hearing this), there are good argument to suggest high rates are themselves now counterproductive. For example, it’s plain that elevated mortgage rates are contributing to new records for home prices (by keeping resale supply artificially scarce), and money market funds are throwing off in excess of $20 billion per month in income, which is to say free money. If I had to guess, that extra interest income is contributing more to incremental spending than any stock rally at this point.
All of that to say the Fed is probably better served to focus on the incoming data and let the market chips fall where they may unless things get really out of hand on Wall Street. When you think about the about-face in STIRs and bonds in November, it’s important to account for the CTA dynamic — the “one-way buy-to-cover,” as one popular derivatives strategist put it, that saw legacy rates shorts across the managed futures space wiped away in a matter of weeks. Those flows fueled the rally. We lament the suppression of “valuable” market signals in the post-Lehman era, but the signal-to-noise ratio for the Fed in something like an across-the-board shift in CTA positioning is too low to be useful.
When it comes to the actual, incoming data, the Fed’s in a pretty good place, all things considered. As I recapped in the latest Weekly, the balance of the labor market data is highly amenable to a soft landing characterization, notwithstanding the headline payrolls overshoot. The caveat is that between the robust November NFP print, a firm monthly AHE read and the drop in the unemployment rate, the distribution of risks around November CPI shifted a bit such that anything which looks even a semblance of warm could be construed as “confirmation” of the message from the jobs report, with the effect of reinforcing any inclination the Fed might’ve had to convey a “hawkish hold” at the December gathering.
I can tell you, definitively, that although casual observers like El-Erian understandably focused on Powell’s public remarks in recent days, what mattered to traders (serious traders, anyway) were Chris Waller’s November 28 comments. I wrote more about the “Waller doctrine” over the past two weeks than I care to admit or remember. Yes, it was Powell who, during November’s FOMC press conference, effectively declared the September dot plot out of date, unofficially confirming that terminal was reached in July. But it was Waller, nearly a month later, who woke markets up to the idea that rate cuts in 2024 aren’t contingent on a recession or even on any outright economic weakness at all. Instead, the Fed may cut simply to prevent the real policy rate from rising mechanically in the presence of lower inflation. The macro rates space was well aware of that possibility. Everyone else though it was an academic thought experiment until late last month.
That’s the lens through which markets will assess the new SEP. Put as a question: What does the SEP refresh say about the interplay between the expected trajectory of inflation and expectations for the policy rate? To be sure, that’s always the question traders ask about the SEP (what else would they be asking?). But this time, the context is recent Fed communication which plainly suggests that rates should be cut commensurate with inflation declines using a fairly strict, rules-based approach, lest the Committee should risk passive tightening through the real policy rate channel alongside passive tightening via balance sheet runoff, into a growth slowdown. (As a reminder: Assuming the Fed doesn’t hike this week, the 2024 dot has to shift lower unless the Committee intends to remove a cut from next year. The September dot plot tipped 50bps of cuts for 2024, but that was from a higher terminal rate which, absent another hike, won’t be achieved.)
In addition to the trade off between lower inflation and insurance cuts, other questions for Powell this week will (or should, if the financial media has any sense about it) include queries as to i) the risk of reserve scarcity as the RRP facility drains contextualized, perhaps, by the December 1 SOFR hiccup and ii) the tension between what’ll surely be another benign SEP forecast for the unemployment rate and Powell’s long-standing contention that “some” labor market softening will be necessary to return inflation to target.
Finally, no one should let Powell off the hook regarding Waller’s rate cut remarks. If Powell initially refuses to engage when asked about the conditions for, and timing of, any insurance cuts, somebody in the audience needs to mention Waller specifically, and ask Powell whether Waller is correct to suggest the Fed will follow a rules-based approach and cut rates commensurate with falling inflation. And also whether markets should read anything into Waller’s hypothetical timeline (“three months, four months, five months”) around those prospective risk-management cuts.
