Did You Spot The Gorilla In The Fed's Meeting Room?

Monetary policy remains exceptionally loose given one of the fastest rate-hiking cycles seen. Pressure is likely to remain on rate expectations to move higher as the Federal Reserve reluctantly eases back on its December pivot, with the fed funds and SOFR futures curves continuing to steepen.

A famous experiment asks volunteers to watch a video of a basketball game and count the passes. Half way through, a gorilla strolls through the action. Almost no-one spots it, so focused they are on the game. As we count the dots and parse the language at this week’s Fed meeting, it’s easy miss the fact that policy overall remains very loose despite over 500 bps of rate hikes. The gorilla has gone by largely unnoticed.

The Fed held rates steady at 5.5% as expected and continued to project three rate cuts this year. But standing back and looking at the totality of monetary policy in this cycle, we can see that - far from conditions tightening - we have instead seen one of the biggest loosening of them in decades.

The chart below shows the Effective Fed Rate: the policy rate, plus its expected change over the next year, plus the one-year change in Goldman Sachs’ Financial Conditions Index, which is calibrated to convert the move in stocks, equity volatility, credit spreads and so on to an equivalent change in the Fed’s rate.

As we can see, in the three prior rate-hiking cycles the Effective Rate tightened; this time the rate has loosened, by more than it has done in at least 30 years.

It is against this backdrop the Fed’s pivot in December is even more inexplicable. By then it had become clear that a US recession was not imminent. Yet Jay Powell did not push back on the over six cuts that were priced in for 2024.

Since then inflation and growth data have come in better than expected. Still, though, the Fed may cut rates even if there is a smidge of an opening to do so. That would likely prove to be a mistake.

Typically the Effective Rate starts falling before the Fed makes its first cut and continues to fall after. This time around, the Effective Rate’s fall is already considerably steeper than normal – even before a cut is made. The Fed may end up spiking the punch bowl with more booze when the party is already quite tipsy.

The gorilla can be spotted in a number of different ways. Inflation has fallen, but it has done so largely despite the actions of the central bank, not because of them.

The San Francisco Fed splits core PCE inflation into a cyclical and an acyclical component. Cyclical inflation is made up of the PCE sub-components most sensitive to Fed interest rates, and acyclical is compiled from what’s left over, i.e. inflation that’s more influenced by non-Fed factors.

While acyclical inflation has fallen all the way back to its pre-pandemic average, cyclical PCE remains at its 40-year highs. The Wizard of the Fed has been pulling the rate-hiking levers, but they have done little to directly quell inflation.

It’s even worse if we account for borrowing costs. Mortgage costs were taken out of CPI in 1983 and car repayments in 1998. In a recent NBER paper by Larry Summers et al, the authors reconstruct CPI to take account of housing borrowing costs.

Inflation on this measure not only peaked much higher than it did in the 1970s, it is still running at 8%. Again, the question lingering in the air is: … and the Fed is considering cutting rates?

Source: NBER Working Paper 32163

(The main point of the paper is that the reason consumer sentiment indices have been depressed despite falling inflation is that they do include the impact of higher borrowing costs.)

If monetary policy was operating in the way expected, we would expect to see more slack in the economy. Yet this has signally failed to happen. The index of spare labor capacity – composed of the unemployment rate and productivity - has fallen only marginally, and remains stuck at 50-year highs.

Other measures of slack, including capacity utilization and job openings as a percentage of the unemployed are still near highs or remain historically very elevated. Under this backdrop, a Fed cut looks distinctly unwise.

Why did we not see a bigger rise in unemployment or drop in job openings despite the steep rate-hiking cycle? In short, massive government deficits allowed job hoarding.

The Kalecki-Levy equation illustrates the link between corporate profits and private and foreign-sector savings. Simply put, the more the household or government sectors dissave, i.e. spend, the higher are profit margins.

In this cycle, it has been the government’s dissaving that has allowed the corporate sector in aggregate to grow profits and - capitalizing on monopolization and on the unique economic disruption seen in the wake of the pandemic - expand profit margins.

It’s for the same reason that EPS growth has bounced back. (Buybacks also play a part here, but they too tend to happen when companies’ profits are growing, which is much easier when the government is spending like a drunken sailor.) As the chart below shows, there is a strong relationship between EPS and job openings, with EPS growth recently turning back up.

With such little movement on slack, no wonder the fall in inflation was due to factors outside of the Fed’s direct influence, most notably China’s glacial recovery. But that leaves markets in an increasingly precarious spot.

Inflation likely lulled the Fed into a false in of security when it performed its policy pirouette in December. But as was clear then and is clear now, this CPI movie isn’t over yet. Furthermore, any recession the Fed may have been wanting to circumvent continues to look off the cards for the next 3-6 months.

Yet the bank may still cut rates, on limited pretext, so confident they sounded last year that they would. That will inflame stock and other asset-bubble risks even more, at a time when we already have bitcoin making new highs and a dog “wif” a hat buying ad space on the Las Vegas Sphere.

Gorillas playing basketball is a very odd thing; the Fed cutting rates before the last quarter of this year would be even odder. Before then, though, markets are likely to try to re-impose some sobriety by reducing or eliminating the number of rate cuts priced in.