Overview
The Fed gave us a number of interesting signals at its March meeting.
Yes. Firstly, there was a change in the 2025 dot plot of expected interest rates, even though the Fed kept three cuts in the plot for 2024. Inflation has been surprising to the upside. Core services inflation has not moved since October of last year and is settling above the target levels. But they are still signalling that June is the likely date for the start of the cutting cycle.
Secondly, there was a small rise in the long-term projection for rates from 2.5 per cent to 2.6 per cent. This is small but it is the first sign of an increase in the Fed’s view on the neutral rate in this cycle and is something we may have to watch going forward. If the Fed's view on the R* neutral rate starts to change, given the ongoing resilience of the US economy, that means that both inflation and rates are likely eventually to settle higher than in the past.
And they will tolerate more price inflation overall?
We have thought for some time that inflation would average three per cent over the next ten years. The burst higher in inflation in 2021 was not transitory and there are multiple reasons why it will continue to some degree. You have the effect of globalization, which is slow moving; of decarbonization; and of course now defence spending - we already have two live wars, and conflict may have far reaching implications in the years ahead.
They will not say it, but central banks will tolerate higher inflation going forward. Inflation is still nowhere near the target and the Fed's willingness and urge to cut right now shows you that they are willing to tolerate an overshoot.
Anything other than cuts at this stage would have serious implications for stock markets
Yes, the other side of this is that there are financial market expectations of lower rates and markets are desperate for the Fed to keep delivering on those calls right now.
We still have three more rounds of data to see before June and you can understand why the Fed didn't want to rock the boat right now. But the fact is there's a stickiness to inflation. There's good reason for that. The last mile in this fight to get inflation down was always going to be tough. But we have to watch the next two, three months because there is a risk at some point as we go towards June that the data doesn't allow the Fed to cut. That would have consequences for markets.
Risk off?
We have been pro risk since October of last year, believing that a soft landing for the economy would come first and keep stock markets in a positive mood for the first part of this year.
Things have changed. Markets have fully embraced the soft landing view of the economy. And now there is a risk, as I mentioned, of the development of a “no landing” narrative, where expectations swing away from cuts and even conceivably towards some tightening of rates.
We are some way from that but we also always thought that there would eventually be a recession and the risk is that if inflation prints continue to be sticky, the market will be forced to reassess positions.
If you don't get cuts, then you have rates that are higher for longer and then the whole debate we had last year about recession and when we get one will come back onto the table, driven by what will then be a really extended period of relatively high real rates.
We are not there yet.
The 2024 dot plot tells you that, despite the positive surprise on inflation of the last two or three months, this is a Fed which wants to cut and I think they were reaffirming that June will be the moment to start if they are able to do that.
