AI image
The question for the Federal Reserve in December wasn’t if it would pivot, it was when.
nce the decision was framed in this way, the rationale for acting sooner rather than later became much clearer.
Many market participants are currently frustrated because the Fed’s dovish shift led to a 15% rally in the equity market, which they missed. These investors had believed Powell’s commitment to ‘finishing the job’ on inflation and were anxious to avoid a repeat of the 1970s.
But as FOMC officials began to think through 2024, they realized that they had a problem: Their hawkish stance was like a dam holding back an ocean of liquidity and risk appetite. Eventually, they were going to have to break it.
If they waited until after they had already shifted to a neutral stance, they would leave themselves vulnerable to a credibility-straining reversal. To illustrate: Say they waited until March (when I expect y/y CPI will be in the low 2s) to signal a neutral stance or cut, that would have goosed stock markets and unleashed those inflationary pressures. If those easier financial conditions sparked inflation, it could have led to an abrupt change in plans and communication.
By breaking that dam now, while they still have a statement that talks about “the extent of any additional policy firming that may be appropriate”, the Fed retains more options.
If the flood of money into markets and drop in Treasury causes a real inflationary impulse, they can hike again. They can also re-establish stronger credibility simply by waiting longer to cut. The market is pricing in 141 bps in cuts currently compared to the Fed dots at 75 bps. In theory, they can wait until the Sept, Nov and Dec meetings to deliver that.
Secondly, there have chosen to break this dam at a time when the pipeline is stuffed with disinflation:
- The rent component of CPI, which lags behind, is set to decrease significantly based on current market rents.
- Used car prices have fallen, contributing to disinflation over the next three months.
- Energy prices have dramatically declined
- The January and February CPI comparisons, which were +0.5% and +0.4% respectively, will no longer be included in y/y CPI calculations.
US CPI m/m
In effect, the Fed is launching an inevitable inflationary impulse into some disinflationary momentum. If that impulse proves to be strong, they’re in a position to stay hawkish. If the disinflation holds, then the coast is clear.
From their perspective, there is a decent amount of recent history that shows that stock market gains don’t create broad inflation. They will be more worried about falling Treasury yields but even on that front, the fall in yields only brings them back to the top end of the Q42022-Q32023 range, which was undoubtedly tighter than the long period before.
US 10 year yields
To sum up: The Fed had to make a move like this some time. They decided it was better to do it sooner rather than later and I’m having a tough time faulting that thinking.
What’s next? The Bank of Japan rate decision is coming up later today (tomorrow morning in Japan). For them, this kind of thinking could also argue for ending YCC. Global yields have moved down so there’s far less of a chance of a blowup in Japanese bonds. USD/JPY also less one-sided so volatility might not be as high.