“The case for adjustment cuts”

Last week’s excitement in bond markets came courtesy of Governor Waller offering a mechanical rationale for rate cuts. Simply, “If inflation goes down, you would lower the policy rate.” This came, of course, in the context of warnings about financial conditions and other caveats, but as is so often the case, what the markets heard was “so you’re telling me there’s a chance?”.

That doesn’t mean that we disagree with the market’s read of where the Fed’s head is. Fed Governors don’t make too many boo-boos with their messaging, and when they do, it’s often an error of timing rather than content. The market has now priced cuts down to “around 4% by the end of 2024” and while that seems perhaps overdoing the enthusiasm a tad, we suspect that the market has gotten the gist about right.

The new term of art is “adjustment cuts”. One might ask what rates would be recalibrated. Headline PCE, Core CPI, 1-year out market expectations? Still, perhaps we are missing the point in asking for details. The main thing is that the prospect of rate cuts is obviously a welcome hope for some part of the economy: see for example, our dead horse CRE, where, as this article notes, developers have been putting their faith in Fed cuts, though “Betting on rate cuts has been a nerve-racking strategy”. Ya don’t say!? We’re once again reminded that hope really isn’t a strategy, but as we wrote previously, it does seem to die last.

The tightrope that the assumptions of Fed funds cut is walking is of course between the dangers of a reacceleration of growth (Scylla?) and the potential that the cuts being priced in are less about the Fed and more about deteriorating outlook for growth (Charybdis?). Odysseus recognized the need for a risk-based approach. As to the latter, one needs to simply look at the latest GDPNow to see that the previously heady prints are far from being priced in.

However, given this is an election year, perhaps the true terror that all DC fears is a vengeful Trump election victory? Given the stakes involved, perhaps we shouldn’t be surprised that officials are prepared to lose a few shipmates to an inflationary Scylla. The same logic might help us understand other developments: as this article notes, the fiscal spigot is likely to remain open for some time thanks to a shift in rules about some Covid era funding that would extend the eligibility and availability of some of the $350bn of funds earmarked. While the funds had been set aside to help states with lost tax revenue, there has been little need. “State revenue overall has exceeded the prepandemic growth trend since late 2020, and states like California set new records for discretionary spending that is now catching up to them. The quick economic recovery means stimulus funds after 2020 have added to blowout spending, rather than replacing lost state revenue as the Administration claims.” That blowout spending has come in the form of golf course projects, sports stadiums, and swimming pools.

If this sounds a little off-piste, that’s probably because we struggle to see the weakness that would justify “adjustment cuts” at this point. But we do need to recognize that Fed officials and banking supervisors have a much better insight into what’s happening in both the real economy and the banking system. Maybe they know something we don’t?

P.S. Banks may not be in quite as dire of a position as expected if their own recent predictions about deposit cuts come true.