As the last Federal Open Market Committee (FOMC) meeting of 2023 approached, some observers expressed concern about Jerome Powell’s tendency to tolerate market rallies regardless of their impact on macroeconomic variables.
Critics contended that Powell’s approach lacked the necessary assertiveness, a trait that was on display in November when he tacitly allowed a cross-asset surge to occur. Some worry that such market dynamics could potentially undermine the effectiveness of the “last mile” in the ongoing fight against inflation.
“Markets’ affinity for rate cuts loosens financial conditions and increases the Fed‘s concerns about inflationary pressures, thereby delaying the rate cuts that markets are betting on,” wrote Mohamed El-Erian in a December 7 Op-Ed for the FT. He noted that Goldman’s index of financial conditions recorded one of the most pronounced monthly easing impulses on record in November.
As a regular reader, you know that we have discussed the financial conditions reflexivity at length in the wake of the Waller Pivot.
Admittedly, the optics surrounding financial conditions, which are currently as accommodative by some measures as they were in March 2022, may not present an ideal picture. This could imply that the Federal Reserve is not doing all it can to prevent a further escalation of inflation throughout the economy.
As of December 1, the Chicago Fed’s adjusted index of national financial conditions showed the most accommodative conditions since the week of February 25, 2022.
Critics argue that Powell tends to allow optimistic market sentiment to flourish. When he expresses caution or takes a hawkish stance, his comments are often seen as boilerplate and lacking conviction. If you follow Mr. Markets El-Erian on social media, or when he brings his incessant Fed-bashing routine to Bloomberg or CNBC television, you will soon realize that he has a bee in his bonnet for Chair Powell.
Still, from most traders’ perspective, Powell consistently emphasizes that financial conditions are restrictive, even though Wall Street’s measures of financial conditions contradict this perspective.
The above analysis helps to contextualize the December Fed meeting by placing it within the context of the ongoing equity rally and a bond rally that, at the local lows, left US 10-year yields some 90 basis points below October’s intraday cycle highs.
It’s important to recognize that the Fed’s primary responsibility is not to defend specific levels of financial conditions indicators. While the “wealth effect” of higher asset prices can help support consumer spending, recent arguments suggest that such concerns may be less important now than in 2022. The key question is whether the disinflation process is well established, leading to sustainable price growth close to the target. There is room for the perspective that it may not be, which would require the Fed to reassess its approach. The key point is that whether the S&P 500 is at 3900 or 4600 on December 31 is unlikely to be determinative in this broader context.
In particular, there are compelling arguments that high interest rates may now be counterproductive. For example, elevated mortgage rates are contributing to new records for house prices by artificially restricting resale supply. In addition, money market funds generate over $20 billion in income each month, essentially providing free money. It’s plausible that this extra interest income is doing more to increase spending than any stock rally.
With this in mind, the Fed is probably better off focusing on incoming data and allowing the market to adjust unless there is a significant problem on Wall Street. November’s reversal in short-term interest rates (STIRs) and bonds should also be seen in the context of the Commodity Trading Advisor (CTA) dynamic, particularly the “one-way buy-to-cover” phenomenon that wiped out legacy interest rate shorts in the managed futures space in a short period of time. While there may be concerns about suppressing “valuable” market signals, the signal-to-noise ratio for the Fed in a widespread shift in CTA positioning is too low to be helpful.
The Fed is in a fairly favorable position with respect to the actual incoming data. The labor market data supports a soft landing characterization despite the overshoot in headline payrolls. The caveat is that the robust November Non-Farm Payrolls (NFP) print and other favorable indicators have shifted the distribution of risks around the November Consumer Price Index (CPI). Any data resembling warmth could be interpreted as confirmation of the jobs report’s message, potentially reinforcing the Fed’s inclination to convey a “hawkish hold” at the December meeting.
Indeed, Jerome Powell’s recent public remarks have attracted attention, especially from casual observers like El-Erian. However, what really mattered to serious traders were Chris Waller’s comments on November 28th. The “Waller Pivot” became a focal point for traders and discussions around it dominated the discourse over the past two weeks.
While Powell had effectively declared the September dot plot obsolete during the November FOMC press conference, unofficially confirming that the terminal had been reached in July, it was Waller who, nearly a month later, alerted the markets to the idea that rate cuts in 2024 don’t depend on a recession or outright economic weakness. Instead, the Fed could cut rates to prevent the real federal funds rate from mechanically rising in the face of lower inflation. While the macro rate room was well aware of this possibility, it became clear to everyone else late last month.
The upcoming Summary of Economic Projections (SEP) assessment will be viewed through the lens of the interplay between the expected path of inflation and policy rate expectations. Recent Fed communications have hinted at a potential rules-based approach to cutting rates in response to declining inflation, to avoid passive tightening through the real funds rate channel and balance sheet unwinding amid a growth slowdown.
Questions for Powell this week may include inquiries about the risk of reserve shortages as the RRP facility is depleted, especially in the context of the December 1 SOFR hiccup. In addition, the tension between a likely benign SEP forecast for the unemployment rate and Powell’s stance that some slack in the labor market may be necessary to return inflation to target should be explored. Powell should also address Waller’s comments on rate cuts, specifically whether the Fed will follow a rules-based approach to rate cuts in line with falling inflation, and whether there’s any significance to Waller’s suggested timeline for prospective risk management cuts (“three months, four months, five months”).
