Rate cuts delayed not derailed
Below you will find a new commentary by Xiao Cui, CIO Office & Macro Research, Pictet Wealth Management.
- Recent macro data have come in line with our expectations. Growth remains solid but not reaccelerating, and there are tentative signs of resumed progress towards disinflation after a Q1 spike. However, Fedspeak suggests the threshold for rate cuts has risen as officials remain patient about the start of an easing cycle.
- As we noted in our last report “Later and Fewer”, the timing of the first cut hinges critically on the inflationary trajectory and it was a close call between July and September. We now expect two 25bps rate cuts in September and December. If inflation proves stickier than our forecast, the risk of just one cut in December or no rate cut at all this year would rise meaningfully. We stick with the view that the bar is extremely high for a future hike, as it would take a strong acceleration in inflation, not just inflation being stuck above target, to justify a rate increase.
- One recent thesis popular with investors is that higher rates are leading to higher inflation. There are good reasons to think the main channels of monetary policy transmission have weakened this tightening cycle. Structural factors related to the debt structure and specific factors related to the pandemic have boosted the economy’s resilience and contributed to the declining sensitivity of growth and inflation to monetary tightening.
- However, rate hikes are still restrictive, not stimulative. In our view, the net income effect of higher rates – that is, the additional interest income savers earn and spend versus the reduced expenditure by debtors facing higher interest costs, has been less negative than past cycles. But at the aggregate level, the effect is still negative rather than positive.
- Diminished transmission of monetary policy argues for a shallower easing cycle once the Fed starts, with the terminal rate settling above the Fed’s estimate of the long-run neutral rate.
Recent comments from Fed Governor Waller, who has been a bellwether for the committee this cycle, indicated he would need to see “several” months of good in- flation data to support a rate cut, which might be possible at the end of the year. The latest FOMC minutes also reaffirmed Chair Powell’s dovish leanings compared to the median policy maker. With the labor market staying solid, it would be difficult for the doves to make the case for a rate cut as early as July.
We have therefore pushed the timing of the first rate cut to September. In our view, rate cuts are delayed, not derailed. The latest CPI report showed the first sign this year that inflation may be slowing. We expect inflation can continue slowing in the months ahead, driven by a deceleration in wage growth, falling shelter infla- tion, and a slowdown in certain supercore categories including vehicle insurance and financial services. We have pencilled in core PCE (the Fed’s preferred gauge of underlying inflation) averaging between 0.20-0.25% MoM in the next six months, a sharp slowdown from its pace of 0.36% in Q1. If our forecast materialises, 6m annu- alised core PCE inflation reading would start improving visibly by the September FOMC meeting.
We have previously argued the Fed can of course move around elections, and they had. But they may very well consider refraining from making their FIRST policy change so close to the election, so as not to signal great urgency – former president Bill Dudley argued against moving at the November 2016 meeting (six days before the election). We therefore continue to see the risk tilted towards a later start to the cutting cycle, with just one rate cut at the December FOMC this year.
The tapering of QT (Quantitative Tightening), a slowdown in the pace of the Fed’s balance sheet runoff, is on track to start in June. The Fed aims to reduce the size of the balance sheet without causing undue damage to the funding markets. This is a technical concern and should have little bearing on interest rate policy.
