The Fed: diluting the punchbowl?

Former Fed Chair William McChesney Martin was the longest serving Fed Chair, serving almost 19 years until January 1970. He is famous for his description of the Fed’s role as being one akin to "taking away the punchbowl?just as the party gets going".

The Federal Reserve’s Federal Open Markets Committee (FOMC) decision overnight to reduce the policy (federal funds) rate by a further 25 basis points (bp) to a target of 4.25-4.50 per cent is not quite consistent with that analogy, but Fed Chair Powell’s subsequent press conference commentary is a nod in that direction.

Certainly, that commentary and the newly issued “dot plot” that accompanied the decision suggested that the punchbowl’s potency might need to be diluted in 2025 – at least compared with expectations prevailing prior to the FOMC meeting.

In his press conference, Fed Chair Powell described the decision to cut the policy rate as a “closer call”. He added that the Fed was in a “new phase” of caution after having eased reasonably forcefully. In a hawkish intonation, he added (McChesney Martin style) that going forward “…we are in a place where the risks really are balanced, and we need to see progress on inflation…” (my emphasis).

The newly minted “dot plot” wound back the median expectation for policy rate cuts for end-2025 from 100bps to just 50bps. That took the median projection to 3.9 per cent for end-2025 from the 3.4 per cent projected back in September.

The decision and accompanying “dot plot” in my view should not come as huge surprise. Certainly, progress on inflation looks to have stalled since the last meeting while the labour market has shown surprising resilience reflecting stronger than expected economic activity growth.

The latest Atlanta Fed GDPNow for the fourth quarter is still a healthy – even robust – 3.2 per cent.

That followed a reasonably robust November payrolls report showing a healthy 227k rise in employment, healthy wages growth at 4 per cent and an unemployment rate, which at 4.2 per cent was running below the median Fed projection issued in September.?

The November consumer price index (CPI) report, however, revealed that measures of the “inflation pulse” indicate ongoing and troublesome “stickiness” in inflation.

The 3-month annualised core CPI was 3.7 per cent in November, a stark deterioration from a trough of 1.6 per cent in July 2024 and was the highest since January 2024. Similarly, the 3-month annualised Cleveland Fed trimmed-mean measure rose to 3.4 per cent in November from a trough of 2.0 per cent in July 2024 and was also the highest since January.?

The November CPI report will reinforce ongoing concern regarding the “stickiness” of services inflation. The 3-month annualised rate of services inflation (or “pulse”) was running at 4.1 per cent, while the “services less rent-of-shelter” measure (a favoured focus of Chairman Powell) was running at 4.5 per cent, the highest since January 2024.?

These trends are more than indications of “stickiness”. They arguably border on indications of a reversal of the disinflation trend that appeared to emerge around the middle of the year.?

That is only emphasised by the incoming Trump Administration’s economic policy agenda which includes large tax cuts and tariff increases likely to exacerbate inflationary trends. Powell conceded that some participants may have factored in those sorts of risks in their interest rate and economic projections, although he added (significantly in my view) that part of the upward revision to inflation reflected developments to date in 2024.

Against that backdrop, The median projection for the core private consumption expenditures (PCE) price index was revised slightly up to 2.5 per cent for 2025 from the 2.2 per cent projected in September. That 2.5 per cent is still some way north of the 2 per cent target.

The unemployment rate projection for end-2025 was revised marginally to 4.3 per cent from 4.4 per cent.

The dialling back of the expected amount of easing implied by the newly issued projections saw equity markets retreat, bond yields rise sharply and the yield curve flatten and the USD appreciate.

Today’s FOMC announcement and Powell’s press conference suggest that in 2025 financial markets will prove challenging for investors: inflation is “sticky”; a mercurial President is threatening to implement a controversial (and probably inflationary) agenda; and risk markets are priced for perfection (reflecting a liberal imbibing of a potent punchbowl).

The big question is whether the Fed’s dilution in the potency of that punchbowl is a harbinger of a more sober assessment of risk markets in 2025.?

RBA: February is still ‘live’…just

In the wake of weaker than expected private sector activity growth revealed by the September quarter national accounts and a revelation following the Reserve Bank of Australia (RBA) Board press statement following the meeting on December 10 that “the Board is gaining some confidence that inflation is moving sustainably towards target”, markets moved to view a greater likelihood of a February easing of monetary policy.

Those hopes suffered a setback with the release of the November labour force report showing continued growth in employment and a decline in the unemployment rate to 3.9 per cent. The latter figure is well below RBA estimates of the non-accelerating inflation rate of unemployment (NAIRU) of around 4.5 per cent.

A less than disciplined approach to government spending from both the Federal and State governments also remains challenging to the prospects of a February rate cut.

Yesterday’s release of the Mid-Year Fiscal and Economic Outlook (MYFEO) revealed Federal Government spending as a share of the economy is at its highest in almost 40 years. It was at that time under the Hawke-Keating government that policymakers – for too brief a period – started to get serious about excessive government spending and attendant structural budget deficits.

A similar observation might be applied to the consideration of structural impediments to growth sustainability and the insulation of the economy from the adverse consequences of inflationary shocks. Governments have long averted their eyes to structural policy and productivity enhancement initiatives.???

In any case, and despite unhelpful Federal and State government policies (from a pure inflation standpoint), if trimmed-mean consumer price inflation is below the RBA’s 3.4 per cent projection for the December quarter as contained in the November Statement on Monetary Policy (SoMP), that could probably shift the balance toward a February cut, especially if estimates of the NAIRU were to be revised downwards.?

Inflation appears to be declining at least in line with the RBA projections. The November SoMP projection revealed a very marginal acceleration in the expected rate of disinflation compared with the August projection.?

Importantly, given the Board’s dual mandate, the labour market has shown resilience, and that resilience is forecast to continue, albeit with some slight rise in the unemployment rate.?

However, as the Board has noted for some time now “[t]here is a risk that any pick-up in consumption is slower than expected, resulting in continued subdued output growth and a sharper deterioration in the labour market.”

There is, as yet, no evidence of that “sharper deterioration in the labour market” but nor is there evidence of any pick-up in household spending. Indeed, the Board noted in the December Statement accompanying its meeting that “incomes and consumption had recovered a little slower than forecast”.

The Board also noted that “wage pressures have eased more than expected in the November SoMP”.?

That likely reflects very weak private sector wage growth.?

However, languishing productivity growth means that unit labour costs (the most relevant labour cost guide to inflation) are a little “sticky”, even if some of that productivity weakness is attributable to “technical” compositional factors associated with strong growth in non-market sector employment and a decline in mining output.?

Despite those “technical” factors, and as stated above, governments (federal and state) have not had their eye on the productivity ball for some time. A plethora of unnecessary regulatory obligations together with the adverse impact of a number of industrial relations measures make it difficult to confidently forecast a meaningful rebound in productivity in the market sector.??

In any case, a deterioration in the labour market remains a non-trivial risk and one to which the RBA would certainly need to respond.?

The other factor that hitherto has received little attention is that for whatever reason (as hard as it is for this writer to fathom one) the NAIRU might well be below current RBA estimates of around 4.5 per cent.?

The NAIRU is a notoriously difficult item to measure accurately but a NAIRU of say around 4 per cent would be consistent with slowing wages growth.?

If the RBA were to come to a similar view, that would remove a key hurdle to a policy rate reduction particularly if weakness in private demand and attendant fragility in the labour market were to manifest in lower inflation pressures.????

Markets have recently started to push out the likelihood of the first cut in the policy rate to as late as May and beyond.?

Fair enough, but I wouldn’t rule out February…yet!

Stephen Miller is an Investment Strategist with?GSFM. The views expressed are his own and do not consider the circumstances of any investor.