January Meeting: Hope versus Caution

What happened in December

On December 13th, 2023, in addition to announcing its decision to maintain its restrictive rate policy and continue its program of quantitative tightening (QT), the Fed published a revised set of economic forecasts, which include GDP, unemployment, inflation, and the Fed Funds rate itself.^[1]

The previous forecasts, released in September, assumed a further rate hike by the end of 2023 (rates did not increase in the end) and only two interest rate cuts in 2024, implying a target rate at 5.1%.^[2] The latest figures are predicting three interest rate cuts and a target rate of 4.6% by the end of 2024.

Fed Chairman Jerome Powell’s language is routinely scrutinized by the markets for indications of future developments. Up to now, he has emphasized the need for caution. His statement that the topic of easing restrictions ‘begins to come into view’ and is now ‘clearly a topic for discussion’ caused a stock market rally.^[3]

While subsequent statements by Fed officials aimed to quell the exuberance, the change of language was taken as a decisive indicator of a ‘pivot’, and markets have begun to price in rate cuts beginning in March, with some expecting as many as six in the coming year, as of the time of writing.^[4]

Inflation

The latest CPI inflation figures released on January 11^th, 2024 came in slightly higher than expected, increasing 0.3% from the previous month and 3.4% from the previous year, largely due to higher housing costs.^[5]

^{Source: US Bureau of Labor Statistics}

This is a significant improvement from December 2022, when CPI inflation was at 6.4%, and considerably below the 40-year peak of 9.1% earlier that year.

However, the latest data indicate that inflation is not necessarily on the retreat, and could potentially rise again. Fed Governor Michelle Bowman and Dallas Fed President Lorie Logan took the opportunity to remind markets that this could mean more rate hikes.^[6] Fed President Loretta Mester has been explicit in saying that cutting in March would be ‘too early’.^[7]

On January 16th, Fed Governor Christopher Waller gave a lengthy speech at the Brookings Institution, entitled ‘Almost as Good as It Gets…But Will It Last?’.^[8] The talk acknowledged the progress made so far, but emphasized the need for sustained progress. He added that rate cuts would be appropriate if, and only if, inflation did not rebound or stay elevated. In other words, it is too soon to celebrate.

Looking at the figures, while unemployment remains below 4%, GDP growth appears to be slowing, implying that the labor market could cool and provide further downward pressure on wages and therefore end prices.^[9]

It is likely that the full effects of higher rates - for example on homebuying, car purchases, and credit spending - have yet to fully work their way through the system. All of which point to a continued era of caution rather than a pivot to the past.

Conclusion

While the future is as uncertain as ever (and always will be) the past month has been an instructive lesson in how emotion can trump reason.

For a variety of reasons, many investors desperately want to return to an era of low or ultra-low interest rates, and are hence pre-disposed to overinterpret indications that we are heading there.

Over-reacting in this way could lead, as Sonal Desai of Franklin Templeton has pointed out, to higher market volatility in the coming months.^[10] From our perspective, it underscores the wisdom of a patient investment strategy, in which temporary swings are meaningless in the long term.

^[1] U.S. Federal Reserve
^[2] U.S. Federal Reserve
^[3] Wall Street Journal
^[4] CME FedWatch
^[5] Bureau of Labor Statistics
^[6] CNBC
^[7] CNN Business
^[8] Federal Reserve
^[9] St. Louis Federal Reserve
^[10] Franklin Templeton