Fed’s soft-landing mirage could morph into higher-for-longer again

The recent pick-up in US inflation has called into question the “soft-landing” scenario that most were projecting just three months ago. The implicit decline in macro risks of high inflation and a growth recession—when economic growth slows but not by enough to call it a recession—had created buoyancy for most asset classes.

The greater-than-expected moderation in core personal consumption expenditure or PCE inflation and the dovish stance of the Federal Open Market Committee (FOMC) in December 2023 guiding for three rate cuts in 2024 instead of two emboldened markets to price in six rate cuts by the end of 2024.

But the US Federal Reserve’s guidance of an early pivot was facile and as the data rolls out, it may have to tone down its optimism. Contrastingly, if the current momentum sustains, core inflation will start turning up around April-May 2024, forcing the Fed to change its course, quite like it abandoned its transitory inflation thesis in 2021.

Curve inversion predicted a recession, but the economy expanded solidly

The prognosis of an impending recession was rooted in the extrapolation of the historically steep yield curve inversion (10 years to 3 months at 190 basis points or bps, mid-2023) induced by the 550-bps rate hike by the Fed.
The theory behind the yield curve inversion leading to a recession is centred on the assumption that Fed rate hikes, quantitative tightening (QT) and rise in real interest rates would slow consumption demand, increase savings, and deflate prices.

As it happened, not only has consumption remained above trend, but the saving rate declined to historical lows and inflation remains much above the Fed’s target of 2 percent. Consequently, the yield curve inversion is unwinding before the realisation of a recession leading to a significant surge in long-end yield (10-year at 4.32 percent).

The misplaced expectations forced upward revisions in the Fed’s growth projections for 2023 from 0.4 percent to 2.6 percent and 2024 real GDP placed at 1.4 percent year-on-year (YoY) is 2.4 percent higher than the projection made at the beginning of 2023.

Macro policies remained benign fearing a recession

The paradox of the steepest curve inversion and a strong economy arose from the restrained withdrawal of the gargantuan post-COVID stimulus by both the government and the Federal Reserve premised on the fear of an impending recession. Thus, the calibrated normalisation has implied that:

a) the estimated real interest rates (1-year US Treasury minus mean PCE inflation) at 1.6 percent is much lower compared to earlier tightening cycles,
b) inadequate Fed QT meant that while the money supply to GDP ratio has declined from the post-COVID peak of 90 percent to 73.5 percent, it remains the highest in the pre-COVID history. Total assets of the Fed declined only $1.3 trillion, i.e., 27 percent of the $4.8 trillion expansion in the aftermath of the pandemic.c) Fiscal impulses turned positive in 2023 after a brief period of drag in 2022.

Fed’s tightening ineffectual

With macro policies remaining benign, the transmission of the Fed’s tightening failed to create restrictive financial conditions, thereby having an insignificant impact on inflation.

The Chicago Fed Financial Condition Index has become deeply accommodative over three months and is now as easy as it was before the rate hike cycle in March 2022. It indicates that the Fed’s monetary management is still impelled by experiences of benign inflation over the past three decades unlike the 1970s and 1980s when its restrictive stance was more effective.

Consequently, it would be fair to say that the moderation of inflation from the post-COVID peaks came largely from the easing of global supply shortages.

Households facing easing financial conditions
For American households, the peak tightening of financial conditions was experienced at the onset of the Ukraine-Russia conflict (March 2022) which triggered spikes in food and oil prices and reinforced the perception of aggressive rate hikes by the Fed.

Since then, their financial conditions have continued to improve and gained momentum recently. Despite the rise in serious delinquency in certain segments, mainly credit cards and auto loans, the perception of financial conditions has improved. The household net worth/disposable income ratio has bounced back to 7.34x as asset prices buoyancy remains higher than the pre-COVID levels.

Labour market and household incomes remain buoyant
The post-recession gains in employment have been the fastest. It only took 27 months to recover to the pre-crisis levels, nearly a third of the post-GFC (global financial crisis) 2008 recovery and half of the post-dotcom bust recovery. Non-farm payroll in January at 157.7 million was 3.5 percent higher than pre-COVID levels.

The strong employment gains and lower than pre-COVD labour force participation rate (LPR, 62.5 percent in January 2024) have extended the tight labour market situation and rising wages. Hence, the cost of labour is averaging at 4.9 percent (four-year compound annual growth rate), nearly three times higher than the 2009-19 period.

Real consumption trending higher

The cumulative effect of a robust labour market and household income, and their optimistic perception, reflected in the real PCE rising 1.1 percent higher than the post-GFC trendline.

At 3.2 percent YoY in December 2023, the pick-up in PCE since October 2023 has been broad-based, spanning all major categories of goods and services. Core consumption (excluding food and energy) grew higher at 3.6 percent. Thus, with core PCE inflation at 2.9 percent, the nominal core spending also picked up pace to 6.5 percent in December 2023, rising from 5.6 percent in October 2023.

House price boom and above-trend consumption to test Fed’s soft-landing premise

The robust household situation is contributed by the continued housing bull phase. The Case-Shiller price index is over 44 percent higher than pre-COVID levels. Thus, the rise in the mortgage delinquency rate, which is inversely correlated to house prices, has remained low at 0.8 percent, rising modestly from the post-COVID lows of 0.3 percent.

The buoyancy in house prices has sustained the uptrend in shelter inflation (5.8-6 percent), which has a 45 percent weight in core CPI. The likelihood of pipeline pressure from shelter inflation inducing higher core inflation emerges both from supply-side factors and easy financial conditions.

The lock-in effect wherein existing homeowners are holding back sales in anticipation of better price realisation has overpowered the demand impact of the 26 percent decline in housing starts from the post-COVID peak.

Also, the pace of completion of houses has slowed in the last six months and remains significantly lower (-12.5 percent) than the houses under construction. These factors are sustaining housing supply shortages.
Thus far the rise in mortgage lending rate (peak rate for 30-year loans/advances at 7.8 percent in October 2023, currently at 6.9 percent) and declining affordability have not significantly impacted delinquency levels.

The house price boom is having a second-order impact on rental inflation as deteriorating affordability leads to increased demand for rental houses. A potential house price meltdown hinges on the possibility of a rise in the delinquency ratio to at least 3x from the current levels, which looks unlikely immediately.

Inflation momentum picking up
The January 2024 prints of both core CPI and core PPI show a month-on-month (MoM) rise of over 40 bps, much higher than the average 20-bps rise required for the core PCE inflation to meet Fed’s downwardly revised projection of 2.4 percent for 2024 (FOMC SEP December 2023). SEP is Summary of Economic Projections.

The disaggregated CPI data shows that three months’ annualised inflation has risen for food (3.2 percent), energy services (11.4 percent), services ex-energy (6.6 percent), shelter (5.7 percent), transportation (8.7 percent) and medical (7 percent). Net of items that have seen moderation (mainly autos), the core CPI inflation has risen to 4.1 percent (three months annualised) versus 3.9 percent YoY in January 2024.

Thus, if the current pace of price momentum continues, it is likely that both core PCE and CPI inflation could bottom out soon and can compel upward revisions in the Fed’s inflation projections once again.

Incremental data is quickly corroborating our suspicion that quite like in the early 1970s, a premature accommodation when the economy is still above trend can cause inflationary impulses to relapse, especially in the current context of rising protectionism. These possibilities will have a significant bearing on the Fed’s future stance, which can veer back to the higher-for-longer stance.

Market expectations have already started realigning, with the year-end 2024 Fed rate projection rising by 60 bps since December 2023 to 4.6 percent (from 4 percent earlier), compared to the current levels of 5.5 percent. If the Fed indeed turns hawkish in the next meeting, there is a reasonable probability of further realignment.

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