YOUR DAILY EDGE: 19 December 2024

Fed Signals Plan to Slow Rate Cuts, Sending Stocks Lower Having reduced rates by a full percentage point since September, officials penciled in just two cuts next year

(…) “Today was a closer call, but we decided it was the right call,” Powell said at a news conference after the meeting. He later added, “From here, it’s a new phase, and we’re going to be cautious about further cuts.” (…)

New projections released Wednesday show Fed officials expect inflation to be stickier next year than previously anticipated, possibly because of policy changes by President-elect Donald Trump. The projections show officials expect to make fewer rate reductions, with most penciling in two cuts for 2025, down from four at their meeting in September. (…)

“There is an inconsistency” in cutting rates while anticipating firmer inflation “that is difficult to square,” Michael de Pass, global head of rates trading at Citadel Securities said.

The magnitude of the revision to the inflation forecast was broad-based among the 19 officials who participate in policy meetings and incredible given how little officials changed their forecasts for the labor market and growth, said Omair Sharif, founder of the research firm Inflation Insights.

“This wholesale change in their views are clearly tied to uncertainty and risks around as-yet-enacted tariff and immigration policies and have far less to do with changes to the economic landscape,” he said. (…)

Powell said recent data, and not just potential policy shifts, warranted a change in the inflation forecast. The labor market has also been a little sturdier than officials thought it would be when they started cutting in September. (…)

Powell repeated his view that it was possible but too soon to tell if the current situation would differ from an episode in 2018-19, when Trump launched a trade war with China after imposing tariffs on steel and aluminum more broadly.

Back then, inflation was low, and businesses had little experience pushing cost increases along to customers. The inflation shock of 2021-22 means that the psychology regarding inflation might have changed in ways that make companies and workers more comfortable passing along higher prices and demanding higher wages, respectively. (…)

Powell said officials were ready to slow down cuts because of uncertainty over how restrictive their policy stance would be after having made a full percentage point in cuts. (…)

The one thing that comes out of Mr. Powell’s presser is that the Fed has become worried about inflation. The focus has moved back from the labor market to inflation.

• “inflation is higher this year. It’s also higher in the forecast next year.”
• “I think that the lower—the slower pace of cuts for next year really reflects both the higher inflation readings we’ve had this year and the expectation inflation will be higher.”
• “You saw in the SEP that risks and uncertainty around inflation we see as higher.”
• “Uncertainty around inflation, I pointed out, is actually higher.”
• “our forecast for inflation for this year, I think, are five tenths higher than they were in September.”
• “that might be the single biggest factor, is inflation has once again underperformed relative to expectations.”

And it’s mainly because of potential tariffs:

• “So the overall picture, the story of why inflation should be coming down, is still intact, in particular the labor market. Look at the labor market. It is cooler by so many measures now, modestly cooler than it was in 2019, a year when inflation was well under 2 percent. So it’s not a source of inflationary pressures.”
• “overall you’re not getting inflationary impulses of any significance from the labor market.”
• “What the committee’s doing now is discussing pathways and understanding, again, the ways in which tariff-driven inflation can affect—tariffs can affect inflation in the economy, and how to think about that. So we’ve done a bit of—good bit of work, all of us have, each of us has. And, you know, it puts us in position, when we finally do see what the actual policies are, to be—to make, you know, a more careful, thoughtful assessment of what might be the appropriate policy response.”

The word “uncertainty” came out 12 times during the presser. Powell summed it up like this:

• “It’s not unlike driving on a foggy night or walking into a dark room full of furniture. You just slow down.”

Particularly if you know somebody is about to move the furniture around.

For investors, this is reassuring because, apart from a recession, the main risk is inflation.

• “So the outlook is pretty bright for our economy.”
• “So we and most other forecasters still feel that we’re on track to—you know, to get down to 2 percent. It might take another year or two from here. But I’m confident that that’s the path we’re on. And, you know, our policy will do everything it can to assure that that is the case.”

My yesterday post was interesting coming just before the policy announcement:

• Over the past three months, control-group sales increased an annualized 5.6%, boding well for fourth-quarter GDP.
• The headline S&P Global Flash US PMI Composite Output Index rose from 54.9 in November to 56.6 in December, signaling the fastest expansion of business activity since March 2022.
• Activity levels were expanded at an increased rate in December in response to strengthening demand. New orders rose at the sharpest rate since April 2022.
• New orders for services rose at a rate not witnessed since March 2022
• Average prices charged for goods and services rose only very modestly, increasing at the slowest rate since prices began rising in June 2020.
• The latest easing pushed the rate of inflation further below the pre-pandemic long-run average, with an especially low rate of inflation again evident in the services economy, where charges rose only marginally and at the slowest rate since May 2020.
• Input cost inflation also slowed when measured across both goods and services, dipping to the lowest for ten months.
• lower cost growth in services was in part due to weaker wage growth
• The service sector expansion is helping drive overall growth in the economy to its fastest for nearly three years, consistent with GDP rising at an annualized rate of just over 3% in December.

• Business Inflation Expectations Decreased to 2.0 Percent

Mr. Powell also said: “Longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets.”

The very people who actually decide to raise prices are currently not expecting inflation to perk up, are they?

Looking back, by about what percent did you change prices over the last 12 months? Looking ahead, by about what percent do you expect to change prices over the next 12 months?

John Authers today:

(…) Higher yields attract yet more fund flows into the dollar. The Fed’s hawkish tone means that there is no end to that pressure in sight. (…)

That at present is causing particular pain for Brazil, whose stock market is now down more than 30% for the year in dollar terms. The central bank hiked by a full percentage point last week, and has since intervened by auctioning off dollar reserves, yet that hasn’t stopped a serious run on the Brazilian currency and bonds:

Brazil’s problem is rooted, as Points of Return explained earlier this week, in a serious fiscal deficit, and a crisis of confidence in President Luiz Inacio Lula da Silva, who emerged from brain surgery at the weekend to say that the economy’s only problem was that interest rates were too high. The rise in yields since then shows that the market emphatically disagrees, and is alarmed by an apparent lack of grip. (…)

Like Brazil, the US also has a concerning fiscal deficit, a political setup that seems incapable of dealing with it, and an elderly head of state whose judgment is now widely questioned (with a successor lined up to take over who isn’t much younger). Trump followed his advisers Elon Musk and Vivek Ramaswamy in venting opposition to a congressional compromise designed to thwart a government shutdown, heightening the sense of severe political uncertainty. (…)

In today’s WSJ editorial Good Riddance to the 118th Congress:

(…) All of this speaks to the lack of any spending discipline on Capitol Hill even as annual payments on the national debt now exceed the entire Pentagon budget. If the U.S. dollar weren’t the world’s reserve currency, we’d be a banana republic. (…)

Ed Yardeni:

Investors might also have been upset to learn that the circus is still in town in Washington, DC. The continuing resolution (CR) that would extend federal budgets to March 14, 2025 is running into severe headwinds in Congress. Conservative Republicans in both houses, plus President-elect Donald Trump, and DOGE co-heads Elon Musk and Vivek Ramaswamy have come out against the 1,547-page CR, which almost no one has read. Without a CR, the government will shut down on Friday.

We think that the stock market might remain sloppy through January. Some investors might be planning to take their substantial profits early next year rather than now to defer capital gains taxes. There could be a longshoreman’s strike in mid-January because they oppose automation at the ports. Trump publicly declared that he agrees with the dockworkers. Furthermore, on day one of Trump 2.0, a blizzard of executive orders will likely include a bunch imposing tariffs and authorizing deportation of illegal migrants.

We can’t rule out a 10% stock market correction, but we would view that as a buying opportunity rather than as a reason to panic out of the market since we don’t expect a recession or a bear market. We are still targeting 7000 on the S&P 500 by the end of next year.

The S&P 500 is now sitting on its 50-d m.a.. The more solid 100-d and 200-d m.a. are at 5745 and 5535 respectively.

At 5745, the forward P/E would be 21.8 and the Rule of 20 P/E 24.2. At 5535: 21.0 and 23.3 respectively. At today’s preopening of 5890: 22.4 and 24.8 respectively.

Goldman Sachs:

Congressional leaders released a “continuing resolution” Dec. 17 that would extend government spending until March 14, 2025 and provide more than $100bn in disaster and agricultural aid, among other provisions. Republican support for that legislation in the House already looked relatively weak before President-elect Trump’s statement this afternoon opposing the bill as it currently stands.

Trump’s opposition was unrelated to the main components—he stated support for the spending extension, and the disaster and agricultural aid—so it is possible that a revised package could still pass before the Dec. 20 deadline. Alternatively, congressional Republicans could also attempt to pass a “clean” spending extension to avoid a shutdown, though this would push more items like disaster relief onto the early 2025 agenda, which does not appear to be in either party’s interest.

Despite Trump’s insistence, the odds appear to be against a near-term debt limit increase. Although the debt limit suspension expires Jan. 2, 2025, we expect that the Treasury will be able to continue to borrow under the limit until Q3, so there is little urgency in addressing the issue now, and adding a debt limit increase to the spending extension would likely reduce Republican support for the measure.

That said, the unexpected focus on the debt limit highlights the incoming Trump administration’s motivation to address the issue early.

There are two potential paths to do so. First, if Congress extends spending authority to March 2025, Republicans could attempt to add a debt limit increase to the spending bill they pass at that next deadline. However, at that point the practical deadline for the debt limit will still be a few months away and Democrats are unlikely to support a debt limit increase without important policy concessions (e.g., extension of ACA insurance premium subsidies at a cost of $20bn/yr).

Second, Republicans could add a debt limit suspension to an early-2025 budget reconciliation bill focused on funding immigration enforcement. That said, it isn’t yet clear whether Republicans will follow this two-step strategy—passing a reconciliation bill dealing with immigration and a few other issues early in the year, followed by a second reconciliation bill mid-year to extend tax cuts and make bigger fiscal changes—but this looks more likely than a single bill at the moment.

While the latest developments raise the odds of a near-term government shutdown, we don’t think a protracted shutdown is likely (a short, technical shutdown is clearly possible given the limited time left before the deadline). That said, should a shutdown occur we estimate it would reduce GDP growth in the quarter by 0.15pp for each week it lasted, and would boost GDP growth by the same amount in the quarter following government reopening.