US central bank policy action, reasons, and implications

From the September 18Fed FOMC meeting, we expected a 25bp rate cut and the start of a slow, measured, and deliberate unwinding of restrictive monetary policy rather than the beginning of a policy easing cycle. However, the Fed cut rates by 50bp, a bold and impressive move.

While it may provide some good optics, perhaps support business and consumer confidence, it should be viewed in the context of acknowledging that a pre-set course for monetary policy should not be presumed given the complexity of modern economies and the possibility of dramatic public policy shifts depending on the US presidential election outcome. There could be solid tailwinds for the US economy in a Republican win, given the possible policy changes a 2nd Trump presidency will bring. At the same time, there is growing evidence of a generally slower global growth backdrop, given recent data from other large economies such as China, Japan, and Germany1.

As such given our assessment of the U.S. economic conditions, the outsized 50bp rate cut by the Fed this week was not what we expected. With GDP growth above trend, Q2 at +3% and GDPNOW2 at 2.9% (figure 4), Core PCE at 2.6% for July, Cleveland Fed’s InflationNow3 Core PCE at 2.66 for September (figure 5), the unemployment rate at 4.3% compared with the NAIRU at 4.4%, our economic outlook suggested a 25bp cut would have sufficed as the beginning of this unwinding process, which needed to be gradual, measured and also data dependent.

We also factored in potential public policy changes that could arise under a new Democratic or Republican White House next year. Considering the economic and political variables, we assigned a 30% probability to a 50bp cut; unlikely but not impossible.

We see three reasons why the Fed ‘went big’ with a 50bp cut. Since the rate cut announcement, we have reviewed the FOMC documents and listened to the press conference multiple times. Indeed, a 50bp cut in non-crisis, non-emergency conditions is highly unusual. We believe the decision was driven by the following factors, weighted according to their significance:

First, concerns that the economy, particularly the labor market, may be weaker than the data suggests (30%-40%). Second, a preemptive move to prevent a recession or hard landing (60%-70%). Third, a potential political motivation ahead of the US presidential election (5%-10%).

This aggressive 50bp rate cut implies that it should support select risk-on assets. Why select risk–on assets and not risk-on assets in general? Well, if the Fed is concerned about the labor market outlook, the labor market outlook will not be universally poor across the economy.

Some sectors of the economy are more vulnerable than others to the high-rate related headwinds and headwinds coming from the AI revolution as well as continued geopolitical fragmentation and possible increased traffic and sanctions under a new presidency.

As such sector and regional selection will now become even more important to your portfolio performance. However we do also expect some further broadening of the market to continue, the equal-weight S&P500 index is likely to continue to narrow the performance gap with the cap-weighted index.

In the fixed-income asset class, the same principles apply. Investors need to be more attentive to sector allocation and duration management; shorter duration remains safer than longer duration, as I expect the long end of the U.S. yield curve to bear steepen again. The Fed's actions last week should help alleviate some concerns about tight spreads in the high-yield and investment-grade bond markets. However, just as in equities, we strongly advocate for careful sector selection within this sub-asset class, as we anticipate performance dispersion to become more dominant.

On currencies, the US dollar is likely to regain its strength after a brief bout of weakness given our expectation that the Fed will not need to cut rates as aggressively as the markets are currently pricing. Gold should remain supported given the uncertainty related to the US presidential outcome, public policy, and global factors.

Details - The reasons why we believe the Fed ‘went big’ with 50bp cut:

1) 30%- 40% Weight: Weaker economy than the data suggest, particularly regarding employment and labor data in general. The Fed is concerned about possibly falling behind on labor market objectives in the quarters ahead, thus the Fed is attempting to counter risks with a bold, large, 50bp Federal Funds rate cut.

In our weekly presentations, KSAdvisory Weekly Comment - August 25, 2024- Powell’s Message – “The Time Has Come”, we highlighted the move in the US Unemployment Rate (UR) for July 2024 to 4.3% from 4.1% in June, near the NAIRU rate of 4.4%, and that this should bring into sharper focus the conditions of the US labor market (figure 1). Since monetary policy works with “considerable lags”, we noted that concerns would be that the UR could move up comfortably over the NAIRU rate and, as such, pose a problem and challenge for the Fed. However, on September 6, one day before the Fed’s blackout period, the US Bureau of Labor Statistics released the August unemployment report with the August UR at 4.2%.

On August 21, 2024, the US BLS released its annual benchmark preliminary revisions report, marking downward the number of jobs created by 818,000 over the twelve months from April 2023 to March 2024 (figure 2). This news caught the attention of the markets. However, I did not put as much stress on it since it was only the preliminary revision report, with the final benchmark revision to be issued in February 2025 with the publication of the January 2025 Employment Situation news release. Additionally, the recent release of the Challenger Gray – Announced Job Cuts report states that “U.S. employers have announced 79,697 hiring plans, down 41% from the 135,980 plans recorded through August last year. The year-to-date total is the lowest since Challenger began tracking in 2005. The previous lowest total through August occurred in 2008 when 80,387 hiring plans were announced.”

Lastly, there has been a considerable amount of attention and focus on the Sahm Rule given the rise in the unemployment rate. The Sahm Rule identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months. (figure 3).

Chair Powell has repeatedly mentioned direct and indirect concerns or developments in the labor market, such as the comments in his prepared remarks at the August 23 Jackson Hole Economic Symposium, the post-FOMC press conference, and Q&A:

i. August 23, 2024, Review and Outlook - Chair Jerome H. Powell - At“Reassessing the Effectiveness and Transmission of Monetary Policy,” an economic symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming

“Today, the labor market has cooled considerably from its formerly overheated state. The unemployment rate began to rise over a year ago and is now at 4.3 percent—still low by historical standards, but almost a full percentage point above its level in early 2023 (figure 2). Most of that increase has come over the past six months. So far, rising unemployment has not been the result of elevated layoffs, as is typically the case in an economic downturn. Rather, the increase mainly reflects a substantial increase in the supply of workers and a slowdown from the previously frantic pace of hiring. Even so, the cooling in labor market conditions is unmistakable. Job gains remain solid but have slowed this year.4 Job vacancies have fallen, and the ratio of vacancies to unemployment has returned to its pre-pandemic range. The hiring and quits rates are now below the levels that prevailed in 2018 and 2019. Nominal wage gains have moderated. All told, labor market conditions are now less tight than just before the pandemic in 2019—a year when inflation ran below 2 percent. It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions.” ?

ii. September 18, 2024, Federal Open Market Committee Monetary PolicyMeeting Statement - Press Release

“Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have slowed, and the unemployment rate has moved up but remains low. Inflation has made further progress toward the Committee’s 2 percent objective but remains somewhat elevated.”

iii. September 18, 2024, Federal OpenMarket Committee Monetary Policy Meeting - Transcript of Chair Powell’s Press Conference

a) “As inflation has declined and the labor market has cooled, the upside risks to inflation have diminished and the downside risks to employment have increased.”

b) “In the labor market conditions have continued to cool. Payroll job gains averaged 116 thousand per month over the past three months, a notable step down from the pace seen earlier in the year. The unemployment rate has moved up but remains low at 4.2 percent. Nominal wage growth has eased over the past year and the jobs-to-workers gap has narrowed. Overall, a broad set of indicators suggests that conditions in the labor market are now less tight than just before the pandemic in 2019. The labor market is not a source of elevated inflationary pressures. The median projection for the unemployment rate in the SEP is 4.4 percent at the end of this year, 4 tenths higher than projected in June.”

a) “…we had the QCEW (Quarterly Census of Employment and Wages) report, which suggests that maybe, that not maybe, but suggests that the payroll report numbers that we're getting may be artificially high and will be revised down, you know that.”

b) “The time to support the labor market is when it’s strong, not when you begin to see layoffs.”

2) 60%- 70% Weight - Preemptive, supportive, and timely recalibration of monetary policy. ?

“This recalibration of our policy stance will help maintain the strength of the economy and the labor market and will continue to enable further progress on inflation as we begin the process of moving toward a more neutral stance. We are not on any preset course. We will continue to make our decisions meeting by meeting.”

“We are committed to maintaining our economy’s strength by supporting maximum employment and returning inflation to our 2 percent goal.”

“But ultimately, we think, we believe, with an appropriate recalibration of our policy that we can continue to see the economy growing and that will support the labor market.”

“Our plan of course has been to begin to recalibrate and as you know, we're not seeing rising claims, we're not seeing rising layoffs, we're not seeing that and we're not hearing that from companies that that's something that's getting ready to happen. So we're not waiting for that, because there is-- there is thinking that the time to support the labor market is when it's strong, and not when we begin to see the layoffs.” ?

3) 5% - 10% - Possibly politically motivated

The current FOMC is composed of seven members of the Board of Governors, Powell (Chair), Jefferson (Vice Chair), Barr (Vice Chair for Supervision), Bowman, Waller, Cook, and Kugler. Of the seven members of the FOMC records show three support the Republican Party, and four support the Democratic Party.

After the news of the Fed’s aggressive rate cut, Donald Trump, the Republican nominee for the US presidential election is quoted in the press saying “I guess it shows the economy is very bad to cut it by that much, assuming they’re not just playing politics.” And that “the economy would be very bad or they’re playing politics, one or the other. But it was a big cut.”

Notes, Charts and References:

1. China's GDP growth rate Q2 at 4.7% y-o-y vs.5.1% expected and 5.3% Q1, Japan Quarterly GDP, Q1 -0.3%, Q2 1.8%, 3 Quarter Average at 0.733%, Germany with Q1 GDP at 0.2%, Q2 at -0.1% q-o-q, and many countries experiencing sub-50 manufacturing PMI data.

2. GDPNow – Federal Reserve Bank of Atlanta - The growth rate of real gross domestic product (GDP) is a key indicator of economic activity, but the official estimate is released with a delay. Our GDPNow forecasting model provides a "nowcast" of the official estimate before its release by estimating GDP growth using a methodology similar to the one used by the U.S. Bureau of Economic Analysis. GDPNow is not an official forecast of the Atlanta Fed. Rather, it is best viewed as a running estimate of real GDP growth based on available economic data for the current measured quarter. There are no subjective adjustments made to GDPNow—the estimate is based solely on the mathematical results of the model. In particular, it does not capture the impact of COVID-19 and social mobility beyond their impact on GDP source data and relevant economic reports that have already been released. It does not anticipate their impact on forthcoming economic reports beyond the standard internal dynamics of the model. Latest estimate: 2.9 percent —September 18, 2024 - The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2024 is 2.9 percent on September 18, down from 3.0 percent on September 17. After this morning's housing starts report from the US Census Bureau, the nowcast of third-quarter real gross private domestic investment growth decreased from 3.2 percent to 2.8 percent. The next GDPNow update is Friday, September 27.

3. ClevelandFed InflationNow - The Federal Reserve Bank of Cleveland provides daily“nowcasts” of inflation for two popular price indexes, the price index for personal consumption expenditures (PCE) and the consumer price index (CPI). Nowcasts are estimates or forecasts of the present. The Cleveland Fed produces nowcasts of the current period's rate of inflation—inflation in a given month or quarter—before the official CPI or PCE inflation data are released. These forecasts can help to give a sense of where inflation is now and where it is likely to be in the future.

Figure 1.

?

Figure 2.

Figure 3- Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate(U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. This indicator is based on "real-time" data, that is, the unemployment rate (and the recent history of unemployment rates) that were available in a given month. The BLS revises the unemployment rate each year at the beginning of January when the December unemployment rate for the prior year is published. Revisions to the seasonal factors can affect estimates in recent years. Otherwise, the unemployment rate does not rise.

Source: Sahm, Claudia, Real-time Sahm Rule Recession Indicator[SAHMREALTIME], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SAHMREALTIME, September 21, 2024.

Figure 4 - GDPNow

The growth rate of real gross domestic product (GDP) is a key indicator of economic activity, but the official estimate is released with a delay. Our GDPNow forecasting model provides a "nowcast" of the official estimate before its release by estimating GDP growth using a methodology similar to the one used by the U.S. Bureau of Economic Analysis.

GDPNow is not an official forecast of the Atlanta Fed. Rather, it is best viewed as a running estimate of real GDP growth based on available economic data for the current measured quarter. There are no subjective adjustments made to GDPNow—the estimate is based solely on the mathematical results of the model. In particular, it does not capture the impact of COVID-19 and social mobility beyond their impact on GDP source data and relevant economic reports that have already been released. It does not anticipate their impact on forthcoming economic reports beyond the standard internal dynamics of the model. ?

Figure 5– InflationNow ?

About Inflation Nowcasting The Federal Reserve Bank of Cleveland provides daily “nowcasts” of inflation for two popular price indexes, the price index for personal consumption expenditures (PCE) and the consumer price index (CPI). Nowcasts are estimates or forecasts of the present. The Cleveland Fed produces nowcasts of the current period's rate of inflation—inflation in a given month or quarter—before the official CPI or PCE inflation data are released. These forecasts can help to give a sense of where inflation is now and where it is likely to be in the future.

Our inflation nowcasts are produced with a model that uses a small number of available data series at different frequencies, including daily oil prices, weekly gasoline prices, and monthly CPI and PCE inflation readings. The model generates nowcasts of monthly inflation, and these are combined for nowcasting current-quarter inflation. As with any forecast, there is no guarantee that these inflation nowcasts will be accurate all of the time. But historically, the Cleveland Fed’s model nowcasts have done quite well—in many cases, they have been more accurate than common benchmarks from alternative statistical models and even consensus inflation nowcasts from surveys of professional forecasters. ?

Terms of Use and Disclaimer

This information is provided for educational purposes only and is not a recommendation an offer or a solicitation for any advisory service or specific security. Any references to specific securities are for educational purposes only to help illustrate certain market activities. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Neither is the information contained herein intended to constitute any form of legal, fiscal, accounting, or investment advice. It should therefore only be used in conjunction with appropriate independent professional advice obtained from a suitable and qualified source. No representation or warranty, whether expressed or implied, is made about the accuracy, completeness, or reliability of the information contained herein, except for information concerning KS Advisory S.A.R.L. KS Advisory S.A.R.L. is a registered company in Switzerland, at the address Cours de Rive 4, CH-1204 Geneva, Switzerland.

? 2024 KSAdvisory, SARL