Fewer Cuts?
The Fed funds futures market now shows a 48% chance of a December rate cut, down from 100% on the day of the October Fed meeting. We saw a Bloomberg News headline that read, “Fed Policy in Doubt with Kashkari on the Fence”. However, in December, it is not Kashkari’s doubt that matters most, as he does not vote this year (he’s a voter next year). It is Boston’s Susan Collins.
Collins is a voter who supported both the September and October cuts, but now says she thinks the Fed should keep rates unchanged “for some time” until inflation and employment risks are in balance (i.e., as Powell said, when driving in the fog, you slow down). The market now has 3.3 cuts from here priced in by the end of next year, which is a little more than the 3.2 priced in the day after the October Fed meeting.
Susan Collins’ hesitation to cut further is not really a surprise. We know from the September dot plot that 12 of 19 participants supported cutting in October, but only ten of 19 supported a further cut in December. Meaning two participants were only marginally dovish. The extreme dovishness of market expectations, not just this year but also next, reflected a belief that data would shift some of the hawks to a more dovish stance. It could still happen, but not until government statisticians can produce and release the data after the end of the government shutdown (hint: it will take some time).
Where we sit now is an environment where participants are at odds over three primary factors affecting their policy decisions:
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- Whether tariff-related price increases are a one-off.
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- Whether the current policy rate is near or far from the neutral rate.
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- Whether weaker payroll employment growth is caused by weak labor demand, or weak labor supply related to closed borders and deportations.
Ultimately, it appears the Fed is unlikely to deliver as many cuts as the market was pricing in, owing to lingering inflationary pressures and resilient growth. Significant easing is likely to materialize only under a substantial decline in economic data or (what I think is more likely) a more politically-influenced Fed. Both, of course, have unique consequences, but the latter certainly carries higher medium-term inflation risks.
Shelter Prices Back Near Pre-COVID Averages
The thorn in the Fed’s side the past couple of years has been the significant impact shelter prices have had on the overall inflation index. Those worries appear to be behind us as the index has round-tripped back to the longer-term average of ~3%. The bad part is that the decline in shelter inflation over the last 18 months helped reduce the aggregate inflation picture, and from this point forward, it is probably tapped out.
However, it’s hard to see inflation running away with oil prices making lows and limited wage inflation. While inflation continues to be above the 2% target (I’m in the camp that 3% is the new 2%), barring a significant change in fiscal trajectory, the risks of runaway inflation are probably unfounded.
Wicksell Spread
The Wicksell spread is the difference between corporate bond yields and nominal GDP growth, less some real rate constant. The above analysis uses the variable R* (Laubach-Williams) as the proxy. When the spread is negative, borrowing costs are below nominal GDP growth. This is generally supportive of growth and can be inflationary, as leverage spending increases (i.e., I can borrow at a lower rate than nominal GDP, which makes the debt much easier to service, assuming the project financed is successful).
However, when observing the Wicksell spread, it can cut both ways. When it flips positive, namely when the premium demanded by bondholders exceeds the neutral bond rate for the economy, leverage becomes more expensive, which leads to higher borrowing costs and usually lower inflation.
In the current moment, this spread remains negative, but far less than it was, and inflation is coming down. With the US importing 3% or so of GDP in external capital, foreign buyers will have a say on how much premium is demanded to hold bonds, or accept the discount in a weaker currency. This could add pressure on term premiums and more broadly, the longer end of the yield curve.
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