FOMC Jul-24 minutes show too much inflation paranoia

5 Jul 2024 , 09:34 AM

US INFLATION NEEDS TRIGGERS; BUT WHERE ARE THE TRIGGERS?

Like we deciphered from the Fed statement, the FOMC minutes of the June Fed meeting, published on July 03, 2024 also betrayed a high level of inflation fear. The FOMC members have admitted that disinflation was happening, GDP growth had slowed and that the labour market was in a better balance. However, there was no hint about the timing of the first rate cut. Clearly, the monetary caution of the Fed does not appear to be supported by the recent data flows either on the inflation front or on the growth front. Let us first look at inflation. The PCE inflation (the Fed benchmark) has come in lower at 2.6%. The PCE inflation, based on personal consumption expenditure, has not only tapered but the driver for lower inflation has been pressure on consumption spending. Food and core inflation are consistently coming down, with energy inflation being the sole major concern.

That is the issue. The Fed appears to be worried about inflation at a time when there are few genuine triggers for inflation. Let us look at some of them. Firstly, the GDP growth has sharply slowed in the first quarter to just 1.4% compared to 4.9% and 3.3% in the third and fourth quarters of 2023, respectively. The small growth is also on the back of corporate investing with consumer spending under pressure. Secondly, the labour market is substantially in balance, with the unemployment in the range of 4.0% to 4.1%. Wages have also stabilized, so the fear of labour tightness leading to higher wages and supporting consumption is not valid any longer. Above all, if you break up the inflation; you find that food and core inflation are consistently down. The only risk is coming from energy inflation, which is more cyclical in nature. Being the largest producer of oil in the world, higher energy prices should matter less to the US consumers. That is why, it is looking like the Fed is worried about inflation; when there are not enough triggers for inflation.

CIRCA FED MINUTES (JULY 2024) – OUR 6 KEY READINGS

The minutes of the June Fed meeting were published by the FOMC on July 03, 2024. Here are our 6 key readings from the FOMC minutes and its implications for the future trajectory of interest rates.

• The Fed officials have collectively acknowledged that the US economy was slowing in terms of GDP growth. In addition, the price pressures as represented by the PCE inflation were also tapering. However, the Fed minutes indicate that the members are still advocating “wait and watch” approach to interest rate action.
• While Fed members appear loath to commit on interest rate cuts too early, there is also an additional angle that the Fed can actually afford to wait and watch. About one year back, the apprehension was that Fed rate hikes could lead to a hard landing (economic slowdown). However, nothing of that kind happened and growth stayed robust.
• In fact, if one reads through the noting of the Fed members, they have underlined that producers are also losing pricing power and that has led to a number of price cuts to ensure that consumer demand is not impacted. That is a clear indication that there is a demand trigger and a supply trigger for lower inflation going ahead.
• The language, however, this time around was less sceptical and more cautious. As the Fed suggested, they would prefer to wait for additional information that would give them greater confidence that inflation was moving towards 2%. That may sound abstruse, but it shows that Fed can afford to wait, and so it will wait and watch.
• One interesting word used in the meeting by the Fed members was “Modest Improvement.” That is not entirely wrong if you consider that PCE inflation has just tapered by 20 bps in the last 5 months. This slow progress is one of the reasons, the FOMC members are still cautious despite PCE inflation just 60 bps away from target.
• The one concern that Fed expressed is that the fall inflation may be purely on account of the tight money policy. The question is whether this would reverse if the Fed gives up on its tight money policy and shifts to rate cuts. As of now, nobody really has an answer to that question and the FOMC will really have to bite the bullet to find out.

To sum up, the mood in the FOMC camp has shifted from one of scepticism to one of cautious. That is an improvement. However, there is still a long mental road to traverse, before the Fed embarks on rate cuts. The question is not whether; but when!

FED MINUTES AND THE IMPACT ON CME FEDWATCH

The table below captures the rate cut probabilities over the next 10 Fed meetings, based on the implied probabilities in the Fed futures trading; post the Fed minutes publication.

Fed Meet	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525	525-550
Jul-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	8.8%	91.2%
Sep-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	6.2%	67.3%	26.5%
Nov-24	Nil	Nil	Nil	Nil	Nil	Nil	2.2%	27.9%	52.8%	17.1%
Dec-24	Nil	Nil	Nil	Nil	Nil	1.6%	21.3%	46.4%	26.3%	4.4%
Jan-25	Nil	Nil	Nil	Nil	0.9%	12.5%	35.2%	35.3%	14.2%	2.0%
Mar-25	Nil	Nil	Nil	0.6%	8.2%	26.7%	35.2%	22.1%	6.5%	0.7%
Apr-25	Nil	Nil	0.2%	3.7%	15.8%	30.2%	29.8%	15.6%	4.1%	0.4%
Jun-25	Nil	0.1%	2.3%	10.9%	24.4%	30.0%	21.3%	8.8%	1.9%	0.2%
Jul-25	0.1%	0.9%	5.5%	15.8%	26.4%	26.8%	16.8%	6.3%	1.3%	0.1%
Sep-25	0.7%	4.4%	13.5%	24.0%	26.7%	19.1%	8.7%	2.4%	0.4%	Nil

Data source: CME Fedwatch

Not much has changed in the probabilities post the FOMC minutes. The market is still betting on the first rate cut happening in September 2024. Here is a quick view of the probabilities on a granular basis.

• Post the Fed minutes announced on July 03, 2024, the CME Fedwatch is assigning 73.5% probability that the first rate cut of 25 bps will happen in September. Is there a possibility of pre-emptive rate cut in the July 31, 2024 meeting of the FOMC? For now, the probability assigned to that possibility is only 8.8%, so market believes that a Julyo rate cut is very unlikely. In terms of December estimate, the CME Fedwatch is estimating that by the end of the current calendar year, there would be a 69.3% probability of 2 rate cuts, which is more than what the Fed had indicated in its June Fed statement.
• Let us now turn to the probabilities in year 2025. If you look at the expectation by the end of the first half i.e., June 2025, the CME Fedwatch is assigning a probability of 89% for 3 rate cuts and a probability of 68% for 4 rate cuts. By end of September 2025, the expectation takes the form of 88.5% probability for 4 rate cuts and 70% probability of 5 rate cuts. There is also a 44% probability for 6 rate cuts, which is significant.

The moral of the story is that the markets are expecting aggressive rate cuts. Even if the Fed chooses to go slow in 2024, it is likely to compensate for that with greater aggression in 2025. That is what the post-FOMC minutes Fedwatch is indicating.

READING BETWEEN THE LINES OF THE JULY 2024 FED MINUTES

The FOMC minutes of the June meeting, published on July 03, 2024, has a clear cautious bias; but not a sceptical tilt. The markets are of the view that even if the Fed goes slow in 2024, it will compensate for that in 2025. Here is what we interpreted from the FOMC minutes published on July 03, 2024.

• The positive tiding is that the inflation is moving in the right direction. The only concern that the Fed has currently has is that the move is not quick enough. They are probably influenced by the fact that PCE inflation has moved just 20 bps in last 5 months.
• The Fed members acknowledged that there was still no consensus that the time was ripe to cut the interest rates. The general agreement was that the Fed must not be in a hurry to cut rates, since in a rate cut decision, any reversal can be tough and expensive too. However, they also acknowledged that the inflation was moving in the right direction.
• The members of the FOMC indicated that they would need more data confirmation in the form of consumer inflation, non-farm payrolls, Q2-GDP advance estimates, oil price outlook, decisions of the OPEC on supply, week-on-week data on US oil reserve drawdowns, US consumer confidence etc. Only most of these indicators pointed to 2% inflation, that the Fed feels it will be ready to cut interest rates.
• The following FOMC statement captured the mood. “Members did not expect it would be appropriate to lower the target range for the federal funds rate until additional information had emerged to give greater confidence that inflation was moving toward the FOMC’s 2% objective in a sustainable manner.” This view is, perhaps, also influenced by the last mile inflation control being inordinately difficult.
• If one looks at the FOMC “dot plot” chart, it is still showing a best-case scenario of just about one rate cut in 2024, and that too by 25 bps. Earlier, the Fed had indicated 3 rate cuts by 2024 end, which was toned down to one rate cut in the June statement. However, the CME Fedwatch appears to believe that the Fed was trying to err on the side of caution and that 50 bps would happen by December 2024, with high probability.
• The minutes did reflect some disagreement, with certain members still wanting to keep the option to hike rates open. The last statement by Jerome Powell had almost closed out the possibility of a rate hike. The hawkish members of the FOMC want the rate hike option kept open just in case inflation turns out to be stickier than expected. However, it emanates from the minutes there was not too much buy-in for that argument.
• The summary of the minutes noted that most members of the FOMC saw economic growth “gradually cooling” and also felt that the current policy was “restrictive” enough. In the last 2 years, the Fed has successfully tamed inordinately high levels of inflation without triggering a hard landing in the US economy. That is appreciable.

The mood was best summed by none other than the Fed chair, Jerome Powell, in one of his speeches delivered at Portugal. “ The risks of cutting too soon and risking a resurgence in inflation against cutting too late and endangering economic growth have come more into balance.” The downside risks to Fed decisions, from here, are fairly low.

HOW WILL RBI INTERPRET THE FED JUL-24 MINUTES?

It may be recollected that the RBI had implemented its last rate hike in February 2023 and has since held rates static for the next 8 meetings; including the June 2024 MPC (Monetary Policy Committee) meeting. For the last few months, the status quo was justified on the grounds that elections were on and the government needed to present the full budget. Now, a new government is already in place (Modi 3.0) and the full budget is being presented in the last week of July. While India has been grappling with erratic food inflation, the headline inflation has been consistently under 5% for 3 months in a row. Even if the RBI may not turn entirely dovish in its view, there is a strong possibility that the RBI may undertake a pre-emptive rate cut in its August MPC meeting. Also, high interest rates and high cost of funds are already posing a big challenge for corporate numbers in this quarter.

Having said that, it is not clear if the RBI would cut rates in August before the US Fed changes tack. However, the RBI was ahead of the Fed in calling a peak on rates in February 2023. The question is, how much worse could the oil price situation get from here? The Red Sea crisis is still festering and now Russia has announced supply cuts later this year. That is already putting pressure on oil prices and that can be a source of imported inflation for the Indian economy. If the full budget makes bold reforms, then the RBI will have the incentive to support the fiscal boost with monetary boost. We may get the first signals of a rate cut by the RBI only from the Union Budget undertone!