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The Fed's dovish tilt shouldn't have been surprising
For anyone who maintains a bigger picture view, and ignores the noise of the crowd, Powell's dovish tilt was imminently foreseeable.
Before the Fed’s FOMC meeting, I released a Twitter thread detailing where I saw Fed policy headed.
I concluded that 1) the Fed needs to dial back its hawkishness (as Powell did) and 2) that rates will be CUT in 2H23 (which I continue to expect).
You can view the thread here:
In order to understand why the Fed’s dovish tilt shouldn’t have come as a surprise, one needs to ignore the noise of the crowd and focus on the bigger picture.
In this case, the echoing noises sounded something like this: “financial conditions! Financial conditions! The stock market is up! The Fed’s losing control! Powell must push back!”. As so often happens, the crowd missed the bigger picture.
The Fed’s job is not to ensure that the stock market goes either up or down. Instead, its mandate is to promote stable prices and maximum employment. With the US’ unemployment rate at a very low historical level, but the YoY rate of inflation recently hitting 40-year peaks, the Fed’s focus has been squarely on promoting stable prices.
The Fed’s focus on prices comes after it had continuously underestimated the strength of the current high inflation cycle. This resulted in the Fed aggressively shifting its stance once it realised how far behind the curve it was. With ZIRP & QE continuing until March 2022, the Fed shifted to delivering a string of 75bp rate hikes, beginning just three months later.
Though as is so often the case when one goes from one extreme to another, the Fed has gone from being too dovish, to being too HAWKISH. For just as they were implementing the most aggressive rate hikes in 40 years, high inflation was rolling over.
So much so, that during 2H22, the CPI rose by an annualised rate of just 0.3%.
Take out the impact of SIGNIFICANTLY lagging shelter costs, and the CPI saw outright DEFLATION in 2H22, falling by a HUGE annualised rate of 3.2%!
While MoM data may be volatile moving forward, the high inflation cycle has thus effectively been extinguished.
The BIG shift in the inflation picture meant that the Fed needed to alter its rhetoric — it did just that
The huge deceleration in price growth in 2H22 alongside a VERY hawkish Fed, meant that after having to routinely revise its estimates higher as it continued to underestimate inflation, the Fed’s December FOMC projections are now OVERESTIMATING actual PCE inflation.
Given this, the Fed thus needed to re-calibrate its expectations and messaging.
That is exactly what the Fed, and its current chair, Jerome Powell, did.
Instead of, “inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures”, the Fed’s FOMC statement now reads “inflation has eased somewhat [emphasis added] but remains elevated”. Gone also, is the statement that the Russia-Ukraine War is contributing to upward pressure on inflation.
In his FOMC press conference, Powell noted that “the inflation data received over the past three months shows a welcome reduction in the monthly pace of increases” and that “for the first time … the disinflationary process has started”. While I argue that the disinflationary process started many, many months ago, meaning that this rhetoric still remains WAY behind the curve, nevertheless, for the Fed, this was a dovish shift, and again, it was a shift that was needed.
It’s all about the economy
Will rates hit the Fed’s December FOMC median projection of 5.1%? According to Powell, he “doesn’t feel a lot of certainty” about the level at which rates will ultimately reach. He says it’ll depend on the data that comes in over the months ahead.
Powell also noted that should the Fed mistakenly overtighten, with inflation coming down faster than it expects, then the Fed has the tools to deal with that (hint: rate cuts & QE) — this plays into my second key point surrounding the future of Fed policy, being that I expect rate cuts in 2H23.
As I explained in my earlier Twitter thread, in order to understand where Fed policy is headed, one doesn’t need to focus on, and read into Powell’s every word. Instead, one needs to gain a bigger picture understanding of the economy and where it’s headed:
Powell confirmed this himself when asked about the divergence between the Fed’s current forecasts and market futures pricing of the fed funds rate. Powell wasn’t particularly concerned, simply noting that “it is largely due to the market's expectation that inflation will move down more quickly.” Should inflation move down more quickly than the Fed’s forecasts, then “it will be incorporated into [the Fed’s] thinking about policy”. Translation: the Fed’s future policy decisions will reflect the state of the economy — as they should.
So, why do I expect that rate cuts will come in 2H23? Because I expect both low inflation (including potential YoY CPI DEFLATION ex-lagging shelter) and a recession (most likely severe).
There’s multitudes of data to support such an expectation. Indeed, on the inflation front, the charts provided earlier already show that as opposed to being on the horizon, low inflation is already here. Remember, 6-month annualised CPI has fallen to 0.3%, whilst it’s NEGATIVE 3.2% on an ex-lagging shelter basis.
On the economic front, you can take your pick from a whole host of data points that suggest a recession is on the way. My deeper analysis of the US’ Q4 GDP report revealed a much weaker underlying picture than what was suggested by the headline GDP growth rate of 2.9%.
A key reason that Q4 GDP was weaker than it seemed, was that Q4 growth was driven significantly by net exports (which given as it was driven by falling imports, it actually suggests weakening US demand & a weakening US economy), and the volatile private inventories components.
Excluding these two categories saw annualised growth of just 0.9% — well below Q3 growth of 1.6%, and the 20-year average growth rate of 2.2%.
Retail sales have plunged from 6-month annualised growth of over 13% in January 2022 to NEGATIVE 3.1% in December.
Manufacturing surveys by the Fed’s branches show that the new orders component has fallen off a cliff. Hours worked have now also turned negative. Trending lower, and the next to turn negative, is likely to be employment.
Another data point to add to the list was released Thursday morning (the list only keeps growing), being manufacturers’ orders ex transportation — just as is the case with the CPI, take a look at the major shift in 2H22.
Put all of this data together and it’s not surprising to see that S&P 500 earnings have seen a YoY decline in Q4.
The picture it all paints is clear — a recession is likely to be on the way.
What’s driving both lower inflation and a weaker economy? The decline in the M2 money supply — something that I have been pointing out for many months.
Nothing material has changed from my pre-FOMC expectations to now. This is how things should generally be. Far too many yo-yo after a certain comment from the Fed, or after a single month of conflicting data. While this is sometimes necessary, for the outlook can sometimes shift quickly (i.e. as we saw when COVID hit, and alongside the responses made to it), it can often also suggest that one is WAY too dialed in to the noise, and is missing the bigger picture.
In regards to the Fed, the outlook for its policy will reflect what happens to the economy over the next 6-12 months.
Given that the inflation picture has changed drastically over the past 6 months, the Fed has begun to change its tune, becoming slightly more dovish, as I previously said that it needed to do. Despite the noise from the crowd, the dovish tilt from the Fed thus should NOT have been surprising.
Nevertheless, even after this dovish tilt, the Fed, in my view, continues to remain well behind the curve. Though remember, this isn’t unusual for the Fed — it generally moves with a BIG lag, and doesn’t make wholesale changes all at once.
While often bad for the economy, and a major cause of its boom and bust cycles, the Fed’s lagging moves can make it advantageous for individuals who can focus on the bigger picture — it gives you plenty of time to get ahead of the Fed, and plan accordingly.
Given my expectation for low inflation and a severe recession in 2023, I thus expect the Fed to eventually follow with rate cuts in 2H23.
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