Fed Chairman not in a rush

Chief Economist Eugenio J. Alemán discusses current economic conditions.

The Federal Reserve (Fed) Chairman seems to be happy with the market’s new wisdom regarding the path of interest rates going forward. At a presentation on November 14, he said that the Fed is not in any hurry to reduce rates and is probably pointing to an important repricing (see below) of federal funds cuts coming into play when the Fed publishes the new Summary of Economic Projections and its dot plot after the December Federal Open Market Committee (FOMC) meeting.

Today, the markets have moved to –at most – two rate cuts compared to expecting between four to five rate cuts before the election. The Fed chairman seems to be indicating that since the economy is growing strongly, it may hold off in cutting rates as aggressively next year as expected when the Fed released its September SEP.

Furthermore, the potential for higher inflation depending on if and how the new administration’s policies are implemented next year could also have started to take shape within the Fed and his new comments are probably a reflection of the effect politics is having on monetary policy.

The Fed doesn’t need a new monetary cycle to begin anew, and they seem to be happy with where rates, but especially mortgage rates, are today. These high rates are going to prevent a resumption in mortgage lending and will probably keep real money supply growth contained until they feel more comfortable with the future path of inflation. At the same time, this repricing will allow the Fed to lower interest rates in December and then continue to say that their future moves will remain ‘data dependent.’

Markets are repricing rate cuts: Pick your explanation

One week after the results of the U.S. presidential and congressional election and with a Republican sweep, markets have continued to reprice their expectations regarding the Fed‘s path to lower interest rates. Explanations for the repricing of interest rates include the imposition of tariffs and the deportation of a large number of illegal immigrants by the incoming Trump administration; higher economic growth; the impact of several of Trump’s campaign promises regarding the non- payment of taxes on tips, on social security payments, on overtime pay, etc.; the effects on the US deficit and debt of a potential extension of the 2017 Trump tax cuts; etc.

Then there is one explanation that has been there since before the election that has the potential to keep interest higher than expected. This explanation has to do with the argument that there have been structural changes in the U.S. economy and that it will be impossible for the Fed to lower inflation to 2.0%.

On this last explanation we have written a lot over the last several years, so we are not going to go into it too much here. The only thing we are going to say is that the Fed has a target of 2.0% and they are going to bring down inflation to the 2.0% target. If there have been structural changes that will make it more difficult for the Fed to achieve the 2.0% inflation target, then that means that interest rates may also have to be higher than originally estimated by markets.

But let’s look at each of the other new explanations one by one and see if they hold true.

Tariffs and deportation: Yes, tariffs and deportation of illegal immigrants, if conducted according to campaign promises, have the potential to increase inflation. The effects of tariffs on prices will probably be immediate while the effects of deportations on labor costs will take some time to zip through the economy and affect inflation. Thus, these two policy proposals have the potential to generate higher inflation and will probably keep the Fed from lowering interest rates, or even increase interest rates if prices increase too much, compared to what markets were expecting before.

Higher economic growth: Yes, higher economic growth –economic growth above what is called potential economic growth – could stretch resource utilization and could trigger higher inflation. And if we add a deportation campaign, it could add to the risks of higher inflation. An increase in the productivity of labor, as we have had over the past year or so, if sustained, could reduce the impact of stronger growth on inflation, but in general, we could see higher prices in this environment, which could keep the Fed from lowering interest rates as much as what markets had expected.

Lower taxes: No taxes on social security, tips, and/or on overtime pay, plus the extension of the 2017 tax reform could also trigger higher inflation in as much as economic growth remains above potential economic growth, as we argued above. Lower taxes will increase take-home pay and will give individuals who benefit from those lower taxes more money to spend, raising consumer demand. This could also put pressure on prices and keep the Fed from lowering interest rates as markets were expecting before the election.

Fiscal deficit: The increase in the deficit and the debt will probably have very little impact on the Fed’s decision to continue to cut interest rates and on inflation. We always hear that this is the biggest risk for the markets, and it definitely is, but if you look at what has happened with interest rates in developed countries that have had large deficits for decades and even a larger debt as a percentage of GDP than the US, it is clear that those issues are not going to keep the Fed from lowering interest rates. It is true that Treasury yields may be higher going forward than what they were before the pandemic, but it is all the other reasons, rather than the increase in the deficit and the debt, that will determine where the yields on Treasurys settle.

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Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. Current Situation Index (CSI) and Future Expectations Index (FEI) are the end-results of CCI, covering economic conditions, employment, price, income, and expense. The reading is 100 plus the average of said five factors

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

The Pending Home Sales Index (PHSI) tracks home sales in which a contract has been signed but the sale has not yet closed.

Supplier Deliveries Index: The suppliers' delivery times index from IHS Markit's PMI business surveys captures the extent of supply chain delays in an economy, which in turn acts as a useful barometer of capacity constraints.

Backlog of Orders Index: The Backlog of Orders Index represents the share of orders that businesses have received but have yet to start or finish. An increasing index value usually indicates growth in business but shows that output is below its maximum potential.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by

U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

Conference Board Coincident Economic Index: The Composite Index of Coincident Indicators is an index published by the Conference Board that provides a broad-based measurement of current economic conditions, helping economists, investors, and public policymakers to determine which phase of the business cycle the economy is currently experiencing.

Conference Board Lagging Economic Index: The Composite Index of Lagging Indicators is an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

New Export Index: The PMI new export orders index allows us to track international demand for a country's goods and services on a timely, monthly, basis.

Durable Goods: Durable goods orders reflect new orders placed with domestic manufacturers for delivery of long- lasting manufactured goods (durable goods) in the near term or future.

Source: FactSet, data as of 9/20/2024