The message from policymakers after the meeting of the Federal Open Markets Committee (FOMC) on 31 January was clear — interest rate cuts are coming, but not as soon as the market has been anticipating. For the fourth consecutive meeting, the FOMC kept the key federal funds rate in restrictive territory, at the level of between 5.25 and 5.50%.
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As had been expected, US Federal Reserve (Fed) policymakers removed their bias to tighten policy rates. Language in the official statement referring to the possibility of ‘additional policy firming’ is gone. Instead, officials noted that risks to full employment and low inflation were now ‘moving into better balance’.
It is likely that the recent improvement in the US inflation data is exactly what the Fed wanted to see – Chair Jerome Powell acknowledged the ‘good news’ over the last six months on inflation – but policymakers need to see more of it over a longer period before they are convinced it is time to cut rates.
To underline this point, Chair Powell declared a rate cut was “not the most likely case or the base case” at the next FOMC meeting in March.
Recent inflation data has been reassuring
At the same time as the FOMC was meeting, data was published showing US labour costs cooled by more than forecast in a fresh sign of easing inflation pressures.
The employment cost index (ECI), which measures wages and benefits, increased by 0.9% in the fourth quarter of 2023 – the smallest increase since 2021 – after rising by 1.1% in the previous quarter. The slower pace of growth in the ECI is distinctly good news for US policymakers, suggesting wage pressure is slowing along with goods inflation.
Although there are other, higher frequency metrics — including average hourly earnings figures from the monthly jobs report — the ECI is considered a better gauge as it is not distorted by shifts in the composition of employment among occupations or industries. As such, it is the Fed’s preferred wage measure.
Other signs are also pointing to slowing wage growth. The Atlanta Fed’s wage growth tracker, a 3-month moving average of median pay, has stabilised at the slowest pace in two years. And the January jobs report, out on 2 February, is forecast to show average hourly earnings growth decelerating.
Elsewhere, data published last week on the personal consumption expenditure deflator (PCE), a measure preferred by the FOMC to the consumer price index (CPI), also reassured (see Exhibit 1).
This measure is viewed as more comprehensive and consistent than CPI over long periods. In December, it fell to below 3% for the first time in almost three years. The core personal consumption expenditure index rose by 2.9% year-on-year, down from 3.5% in November and below consensus forecasts. Disinflation is evident in all recent data. The question is whether this will continue.
Why the caution?
According to the policy statement, Fed policymakers want ‘greater confidence’ that inflation really is beaten and moving back down to the Fed’s 2% goal.
Although Chair Powell acknowledged the good news on inflation, he and his colleagues are wary of falling into the trap of easing monetary policy prematurely.
An IMF paper published last September with the title “One Hundred Inflation Shocks: Seven Stylized Facts” noted that: “Most unresolved (inflationary) episodes involved ‘premature celebrations’, where inflation declined initially, only to plateau at an elevated level or reaccelerate.” Central bankers have been warned!
The best-laid plans of mice and men often go awry
An announcement of unexpected problems at New York Community Bancorp (NYCB) delivered a timely reminder that ‘unknown unknowns’ could lead the Fed to abruptly adopt a different approach to monetary policy.
Markets went into risk-off mode, with money moving out of risk assets and into bonds after this New York bank, which took over some of the assets of the failed Signature Bank last year, announced a dividend cut and a loan-loss provision of USD 550 million, mostly for real estate.
NYCB’s stock valuation fell by around 38% on 31 January and the KBW regional banking index fell by 6%, marking its biggest fall since a run on deposits toppled Silicon Valley Bank (SVB) last March.
NYCB’s acquisition Signature Bank assets moved it into a regulatory category that requires higher capital levels. According to reports by Bloomberg News, the company said that this was the reason for the divided cut and the boost to its provision for loans losses.
Problems in the US real estate sector have been a ‘known unknown’ for investors in recent months as property values tumbled and borrowers refinancing faced higher interest rates.
The provision for loans at NYCB was far beyond analysts’ estimates. NYCB is reported as saying it wanted to build up loan-loss reserves to be more in line with other banks of its size and get ahead of potential weakness in the office and multifamily property markets.
But, at the end of the day…
Risk assets had a bad day on 31 January, suggesting stock markets had reckoned with a more dovish message from the Fed. The day had already included results from some of the US mega tech stocks which disappointed in a context where equities has been priced for perfection.
Bonds rallied despite news of higher-than-expected supply in coming months. The news from NYCB drove investors into US Treasures amid concerns that this event may be a harbinger of broader problems in the real estate sector.
Overall, the shift in expectations for rate cuts by the Fed was limited, with the fed fund futures curve ending the day predicting more rate cuts by the end of 2024 than it had before the Fed meeting, despite the Fed’s messaging.
Our multi-asset investment team remains cautious with regard to risk assets. In an environment where central banks are likely to be wary of cutting policy rates pre-emptively and in the absence of certainty about the level of the neutral policy rate, the risks arising from an overly long period of restrictive monetary policy cannot be excluded.
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