Might 2024 See No Rate Cuts? (June 17, 2024)

Hi YXI Friends,

As the first issue of our daily insights, we will examine the various rate-cut scenarios for 2024. The main scenarios range from the 2 cuts currently priced by the market, to the 1 cut implied by the FOMC and even no cuts depending on how inflation plays out.

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Non-farm Payrolls (NFP) vs. Inflation (CPI, PCE)

We start with these two as they are the Fed’s dual mandates, maximum employment and price stability. The two sets of data have also continuously exerted a push-and-pull effect on the market expectations of rate cuts.

Non-farm Payrolls are structurally strong

Due to a large structural supply-demand gap in the labour market since COVID, the employment data have been consistently strong. For example, the latest NFP of 272k jobs added in May was way above the consensus estimate.

(Household survey pointed to a loss of 400k jobs and a higher unemployment rate, but we will discuss this ahead of the Non-farm Payrolls next month.)

There have been two notable shifts in the labour market which have helped the labour market: immigrant workers and women workers.

Nearly 20% of the current US workforce is foreign born. 77.5% of the foreign-born men participate in the labour force compared with 66.1% of the native-born. In terms of the women workers, For women over 20-years-old, their participation rate has edged up from 58.6% to 58.8% in the past year compared with a drop from 70.4% to 69.9% in men. This means 600,000 more women are employed today than a year ago.

The Fed observes that the strength of the labour market has been structural, independent of inflation or interest rate levels. This provides a source of confidence for the Fed to keep the rates high.

In the June FOMC, Powell noted that the 4% unemployment rate we have today is still “historically low”.

Moreover, wage increases have been running above 4% for the entire past year. This creates upward pressure on non-housing services inflation, even if not translated 1-to-1. Again, it provides another reason for the Fed to delay cuts for the time being.

CPI points to an inflation downshift, but have not yet convinced the Fed

Let me first highlight that the Fed’s inflation target is based on the PCE and not the CPI. Conveniently, PCE has diverged from CPI to the downside, by anywhere between 0.5% and 1% in the past 6 months.

The difference is that CPI measures only urban inflation. This means the two datasets have very different component weightings, with the CPI assigning a much higher important to shelter. Moreover, CPI comes out much earlier in the month, providing an advanced gauge of the inflation trend.

However, and this is quite key, the Fed does look at CPI very intently, perhaps more than it should. CPI has an outsized effect on the market’s rate-cut expectations even as it not being the official inflation target.

Last week’s CPI data suggests a rather rapid deceleration in inflation. Headline CPI came in at 0% MoM, Core at 0.2% (both below expectations), and Services less shelter inflation also came in at 0%.

All of the sudden, the 3-months annualised rates all take a dive:

While this provided a sigh of relief to the Fed, Powell remained vigilant in the June FOMC. Looking ahead in H2, the Fed is worried about the base effects pushing inflation figures back higher.

For many months now, Powell has emphasised on the importance of trends versus one-offs. In Q1, when inflation data came in hot, Powell stressed patience in waiting for a full quarter’s readings.

Now, as inflation seems to ease, Powell wants to see a string of positive data before the Fed kicks of a cutting cycle.

The unwelcome importance of Shelter and motor vehicle insurance

The table above tracks the YoY changes in the CPI components as well as their relative importance in the index. Shelter represents 36.1% of the overall CPI, but actually contribute towards 59% of the increase.

Importantly, nearly half of the CPI increase comes from “Owner’s equivalent rent of residences”, which is an imaginary item drummed up by the BLS that house owners do not actually pay. But it flies nearly half a percentage point above actual rent.

While the Fed had expected shelter inflation to ease due to higher interest rates, it has definitely taken its sweet time.

The second unwelcome item is the motor vehicle insurance. It is experiencing a lagging effect of the surging vehicle purchases due to COVID, supply chain bottlenecks for auto parts, and apparently the “increasing number and severity of claims” according to Insurify. Who knew road rage could be holding up interest rates?

Why not cut one and see?

For the Fed, a 25bp cut (or hike) doesn’t really move the needle when the base rates are in the mid-5%. However, the first cut has a very strong symbolic value for to Fed.

To me the Fed wants to lean on the side of caution and be very confident that inflation would not resurge during the cutting cycle. They are still quite a distance from that confidence level.

This was evident from the big shift in the June FOMC Dot Plot for 2024, when the FOMC members moved from expecting 3 cuts straight to only 1 cut for the year. This means the vast majority of the FOMC members shifted their dots up in June, many by 50bp.

This was despite that in the morning of the second FOMC day, CPI came below the expectation as aforementioned. (Note: FOMC members submit their dots on Day-1 of the FOMC but are free to revise it on Day-2).

The Fed Funds futures stick to the 2 cut prediction

The Fed Funds futures market see the most likely scenario for 2024 still being two cuts, occurring in September and December.

The market choice for September is deliberate. September is far enough away for the Fed to see a string of positive CPI data to gain enough confidence for a cut. It also coincides with the release of quarterly Summary of Economic Projections (March, June, September, December FOMCs).

This scenario is backed by the fact that while the Dot Plot median was 1 cut, 2-cuts were the most often choice (8 dots).

What if 2024 is actually a no-cut year?

I am not saying the Fed should keep on delaying rate cuts, but that they don’t have a track record of being on time. This is because the Fed relies on data with significant lag effects. It is also inherently difficult to forecast how inflation would evolve even in the near-term.

While the Fed keeps disclaiming they assess the “balance of risks” between acting too early and too late, the recent tone has been one of patience. This is in contrast to Powell’s December 2023 FOMC Press Conference, in which he might as well have done a victory lap. Powell does not want to be remembered as the Fed chair that let inflation run away. There is also less political pressure to please the incumbent as his in his second term.

Because of the above trend GPD and employment figures, the Fed has less incentive to loosen financial conditions compared with completely nailing inflation.

Basically, the Fed feels it has a lot of cushion right now. What’s the rush? Even Powell himself cannot give a clear answer on why the Fed should cut rates soon-ish, except that the current monetary policy is theoretically “restrictive”.

A quick word from the author

Thank you for joining me on this journey. Feel free to share any suggestions or comments, either directly through email or in the comment section. Your support is greatly appreciated.

— Yimin, June 17, 2024

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.

References

1. BLS: FOREIGN-BORN WORKERS: LABOR FORCE CHARACTERISTICS — 2023

2. BLS: Table A-1. Employment status of the civilian population by sex and age

3. Transcript of Chair Powell’s Press Conference June 12, 2024

4. Insurify Car Insurance Report