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From Fed pivot to Fed pause

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Good morning. On a day when Donald Trump was indicted for fraud and Vladimir Putin called in extra troops, everyone in the financial world could only talk about the Federal Reserve. We participate below. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

the Fed

the Feds Overview of the economic projections (SEP) for September looked very different from the previous one, which was published three months ago. At a high level of abstraction, the change is not surprising. The new SEP just articulated the blunt and emphatically hawkish message of Chairman Jay Powell in, for example, his Jackson Hole speech a month ago. But words leave more room for interpretation, and therefore misunderstanding, than numbers.

There were three particularly big changes:

  • GDP growth in 2022 was reduced from 1.7 percent to 0.2 percent. 2023 got a haircut from half a point to 1.2 percent.

  • The expected key rate for the end of 2023 was upgraded from 3.8 percent to 4.6 percent – a shadow above the 4.5 percent high the futures market had expected for the middle of that year.

  • The unemployment forecast for 2023 went from 3.9 percent to 4.4 percent.

This is meaty stuff, and in line with the repeated message from yesterday’s press conference, which is that rates will not only be high, but will be high long enough to hurt. A taste:

Over the next three years, the median unemployment [projection] above the average estimate of the normal long-term level. . . The historic record strongly warns against premature policy easing. . . Reducing inflation is likely to require a sustained period of below-trend growth and will most likely lead to an easing of labor market conditions. . . We will have to bring our fund rate to a restrictive level and keep it there for some time.

And so on. Judging by the market reaction, it was all a bit more aggressive than expected. The futures market forced out its expectations for the peak policy rate and pushed out the peak from March to May. The bond market took it all well, with a small rise on the short end and a small decline on the long end (tighter policy today, lower inflation tomorrow). The stock market didn’t like the show much; the S&P 500 fell 1.7 percent. But it’s hard to read much into that move in a market that had a lot of downward momentum.

However, two key differences remain between the Fed’s forecast and what the market expects.

The futures market is aiming for a key interest rate of 4.2 percent at the end of next year; the Fed is looking for 4.6. That’s big: It looks like the market expects core inflation to fall enough over the next 12 months for the Fed to start cutting. The Fed thinks otherwise.

But take Powell at his word. Speaking of the interest rate forecasts yesterday, he said they “represent no decision or plan by a committee, and no one knows where the economy will be in a year or more”. That’s the fact, Jack. The Fed’s forecasts don’t say: here’s what we’re going to do. They say, this is what we want to do if core inflation stays above 3 percent. Whether core inflation does or not, your guess is literally as good as theirs.

The second decoupling is more substantive. According to the SEP, unemployment will increase by 0.6 percentage points to 4.4 percent between the end of 2022 and the end of 2023. This is significant. A well-known recession indicator, the Sahm Rule, starts flashing red after an increase in unemployment of 0.5 percentage point or more over a 12-month period. At the same time, however, the SEP calls for GDP to grow by 1.2 percent by 2023 without a recession. Many experts (Unhedged included) can’t figure out how these two things fit together.

For example, here’s Andrzej Skiba from RBC Global Asset Management:

We struggle to understand how the Fed expects unemployment to rise and interest rates to rise above 4.5 percent, while US growth remains between 1.2-1.7 percent over the 23-24′ period. We think that with interest rates now projected to peak significantly above 4 percent, a US recession is likely next year.

RBC does not struggle alone. Here’s Aneta Markowska from Jefferies:

Unemployment has never risen more than 0.5 percent without triggering a recession, so the FOMC is betting the time is different. . . as the Fed’s forecast is extremely unlikely to come true, we see little value in the FOMC’s rate projections beyond next year.

But even if you think the Fed is overly optimistic about the chances of a soft landing, it would be foolish to question its commitment to keep raising rates — not to mention cutting them — until they get much better results. inflation data and significantly tighter financial conditions . BlackRock’s Rick Rieder rightly points out that the next step is not a Fed pivot, but a Fed break:

Today’s question then becomes how close we are to a policy resting place where the Fed could wait in the coming months for restrictive policies to work their way through the economy, allowing the now-famous “long and variable slowdowns” to push inflation back.

How close are we to that? Powell made a telling comment in the press conference that “we believe we need to raise our general policy stance to a restrictive level” and that this means, among other things, “you would see positive real yields across the yield curve and that is an important consideration” .

How close are we to positive real interest rates across the board? On the short end of the interest rate spectrum, an intuitive way to see this is to look at the real policy rate, that is, the federal fund rate minus the Fed’s preferred measure of inflation, personal consumer spending. A fed funds rate of zero plus rising inflation quickly pushed key real interest rates down. We are still in negative territory, but there has been a major change in trajectory (and the Fed is forecasting more of the same).

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At the mid and long ends of the curve, real yields are in positive territory if you use inflation-protected government bonds, or nominal government bonds minus the survey’s inflation expectations, as a benchmark. However, subtracting core PCE from nominal Treasuries still yields negative real interest rates. Core PCE runs at 4.6 percent per annum and the 10-year Treasury at 3.5. Don’t count on a break from the Fed, let alone a pivot, until that gap is much smaller. (Armstrong & Wu)

A good read

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