The Fed: “We Don’t Talk About Rate Cuts – No! No! No!”

The title of this blog was inspired by Disney’s Encanto, a story about a family living in a charmed villa in the mountains of Columbia. Cracks begin to appear in the foundation of the grand villa, and it is Bruno, an ostracized family member, who holds the key to stop the foundation from crumbling. The song from the production referred to here is We Don’t Talk About Bruno – No! No! No!

Cracks are beginning to appear in the economy’s foundation as a result of a monetary policy of high interest rates and a shrinkage of the money supply. But the Fed has continued to suggest that rates will remain Higher for Longer, i.e., they won’t talk about rate cuts!

In past blogs we have discussed the issue that the Fed created for itself in 2012 when it decided to become “transparent,” and began to make public the dot-plots, the individual projections of interest rates by Federal Open Market Committee (FOMC) members, and allowed those members to publicly discuss their individual economic projections and what that would mean for policy.

Prior to 2012, the Fed never gave guidance of any kind. As a result, market players would look for nuanced clues as to what the Fed was thinking, for example, the thickness of Alan Greenspan’s briefcase. Since the adoption of “transparency,” the Fed assumed the difficult task of managing market expectations, and it must now be cognizant of any FOMC member comments which might reflect on policy. This was specifically noted by the Financial Times on Friday (December 1^st) in a story by Colby Smith entitled “Fed shies away from talk of interest rate cuts”.

The hesitation to officially … address more directly the parameters for rate cuts, stems in part from fear that doing so could unleash a wave of looser financial conditions.”

The fact that FOMC members, in recent public comments, have acknowledged that monetary policy appears to be working (the recent inflation data have come in lower than anticipated) has been interpreted by markets to mean that the peak in interest rates is in, and that the next policy move will be to lower rates. Wall Street’s odds for this have recently moved from a rate cut at the 2024 June 12^th meetings to the May 1^st conclave. Note in the chart at the top of this blog that the yield on the 10-Yr. Treasury has come full cycle from early September to December 1^st. At the Fed’s September meetings, in order to manage market expectations so that financial conditions stayed tight, the Fed emphasized its Higher for Longer mantra. And that caused the 10-Yr. Treasury yield to spike from 4.2% to 5.0% by late October. Since then, as inflation has melted and FOMC public comments have acknowledged that additional rate hikes are improbable, 10-Yr. yields have returned to that 4.2% level where they were prior to September’s (Higher for Longer) meeting.

Yet, despite incoming data, this FOMC still believes, or feels it must act like it believes, that the war on inflation hasn’t yet been won, and it wants to keep rates at highly restrictive levels. But the financial markets aren’t cooperating both because the inflation data has come in well below expectations, and because it detects from FOMC member speeches that the Fed is done hiking. Historically, the first-rate cut comes 10 months after the last rate hike which was July 26^th

. That puts the bullseye on the May 2024 meeting.

Housing

Housing is a key component of the economy, and the news there is not good.

Pending Home Sales (new contracts) fell -1.5% in October, and this series is down -6.6% from a year earlier. Of significance, its current level is the lowest in the history of the series which began in 2001. This series is the precursor to Existing Home Sales, which are the completed sales contracts.

Given the chart of Pending Sales shown above, it is no surprise that Existing Home Sales also fell in October (-4.1%) from September levels (and September fell -2.2% from August). October’s number was a 13-year low. Looking back a year, sales are off -14.6%. We are now seeing the beginning of an impact on home prices, as the median sales price was off -0.3%, not much, but a start!

As noted in prior blogs, because most homeowners have mortgage rates in the 3%-4% range, current mortgage rates (mid-7% range, down from 8% in October) have driven inventories of existing homes for sale to record lows. As a result, those who have the means and desire to purchase have flocked to the New Home market. Even there, it isn’t an easy sell. Note on the chart that new home prices are down more than -17% year over year. That, and some buy down of the mortgage rate, is what it is taking to complete sales in this market. And that -17% is yet another sign that inflation is on the wane.

Beige Book

The Beige Book is a compendium of details about economic conditions in each of the 12 Federal Reserve districts. The latest release was, to say the least, downbeat on the economic climate. Four of the districts said economic growth was “modest,” while the other eight noted that conditions were flat or slightly down. Unlike recent such reports, no district reported any real economic growth nor any prospect thereof. As far as the immediate prospects for holiday retail sales, the Beige Book reported: rising price sensitivity; increased discounting, and consumer budget consciousness.

Retail

Speaking of holiday retail sales, initial reports from Black Friday and Cyber Monday indicate that there was a significant increase in customers choosing the buy now, pay later option when buying online, up 19% from a year ago. This looks to be an indication of some strain showing up in consumer budgets.

We noted in our last blog that the Challenger, Gray and Christmas employment specialist firm indicated that plans for seasonal holiday hiring is the lowest in a decade, down -40% from that of 2021. This would indicate that retailers are bracing for slow holiday sales. Best Buy BBY , Kohl’s, Nordstrom, and Lowe’s all reported slumping same store sales in Q3, signaled no pick-up on the horizon, and cut previous guidance for 2023. According to Rosenberg Research, with all but a handful of S&P 500 companies reporting Q3 results, it says a lot about cracks in the foundation when 72% missed on top line revenue and 59% on earnings.

Manufacturing

The latest Manufacturing PMI Indexes from the Dallas and Richmond Feds both continued to show contraction. Dallas’ was -19.9 in November, and that despite record high energy production in Texas. New Orders, Shipments, Production, and the Workweek all fell from their October levels. And, while Employment was positive (+5.0), it was off significantly from its reading of two months earlier, i.e., September (+13.6). Three of the four inflation markers were more negative in November than they were in October.

• Backlogs: -18.1 vs. -12.9 and the lowest since early in the pandemic (April ’20)
• Delivery Times: -8.1 vs. -7.8
• Prices Received: -6.2 vs. -2.1
• Prices Paid: While still rising (+12.6), they were down from +25.0 just two months earlier.

The Richmond Fed’s data were similar. The overall index was -5; Backlogs and Shipments were down and Employment flatlined. Both Prices Paid and Received rose (+3% and 2% respectively), but at a much slower pace than the near 10% rate of a year earlier.

As we have noted in our last several blogs, Manufacturing in the U.S. has likely already entered a Recession.

As in the U.S., the Manufacturing PMIs for all the major European countries (UK, Germany, France, Italy, Spain) were also in contraction, with the aggregate overall Euro area showing up at 44.2 in November (below 50 is contraction) after a 43.1 print in October.

Inflation

The latest inflation data have pleasantly surprised many:

· 0% CPI Month/Month (M/M) October;

· -0.1% CPI ex-shelter M/M October; +1.5% Year/Year (Y/Y) (was +8.2% Y/Y Oct. ’22);

· -1.1% Apartment List Index Y/Y, and now negative four months in a row;

· +0.2% Average Hourly Earnings M/M October; the weakest since February ’22 (where’s the dread wage price spiral?);

· -0.5% Producer Price Index (PPI) M/M October;

· +0.1% Core PPI (ex-food and energy);

· 0.0% services PPI

· -6.5% core crude PPI Y/Y October;

· -1.5% semi-processed core goods Y/Y October;

· -0.3% volume spending on durable goods M/M October;

• Autos: -0.8%;
• Furniture: -2.5%;
• Clothing: -0.3%;

· -0.1% Restaurants (first negative since February).

We think that it is unfortunate that the primary inflation measure is a 12-month look-back (i.e., the 3.2% headline for October uses October ’22 as its base) instead of shorter three- or six-month periods which give a better reading of what is currently occurring. Using shorter periods allows faster (and better) policy responses. In addition, there is a widely known and well recognized flaw in the shelter component (33% weight) of the CPI which we have discussed in depth in past blogs.

The chart shows the CPI (red line), the current (up to date) Apartment List Index which plots actual current rents (purple line), and the rent component of the CPI (blue line). Note the large difference between the Apartment List Index (-1.1% November) and BLS’s index (+7.2% in October). If one excludes the shelter component, the other 67% of items in the CPI rose +1.5% on a Y/Y comparison. And, if we substitute the Apartment List -1.1% figure for the 33% weighted shelter component, the result would show a headline Y/Y CPI of +0.6%. Is it any wonder that the financial markets are moving financial conditions toward ease?

Because the Fed’s economists are aware of these issues, they are able to forecast continued falling inflation. The chart shows the SF Fed’s forecast that by the end of 2024, deflation is more likely to be the buzz word at the Fed.

Final Thoughts

We are seeing rising delinquencies in auto and other consumer loan categories, and, as we have noted in several blogs, the consumer is using every available avenue to continue spending (record high credit card balances, and, as noted above, “buy now pay later”).

These developments portend lower consumption as retailers have sensed for the holiday shopping period (lower seasonal hiring, lower guidance).

As a direct result of Fed restrictive monetary policy, home sales have entered the doldrums. There is no inventory of existing homes for sale, and in order to sell new homes, developers have had to give significant price concessions.

Manufacturing is off, and it is apparent from the rise in continuing unemployment claims (those out of work for more than a week) that the hot jobs market has cooled. We expect that in Friday’s (December 8^th) employment report that the unemployment rate will breach the 4% level.

When we look at other major economies, Europe and China, we see similar slowdowns. In our last blog we noted how China was exporting their deflation to their trading partners.

There is good news, however! The data strongly indicate that the inflation dragon is dying. As noted, because they fear a reignition of inflation, the Fed doesn’t yet want the financial markets to loosen financial conditions. And while the Fed’s economists recognize victory, the Fed’s leadership isn’t yet ready to make that admission. Thus, the attitude that “We don’t talk about rate cuts – No! No! No!” because that would only encourage the markets to loosen financial conditions faster than the Fed desires.

Our view:

• A Recession is coming if it hasn’t already started;
• The inflation war has already been won;
• The longer the Fed waits to move rates down toward neutral (2.5%), the longer will be the duration and deeper the depth of the Recession;
• By the end of 2024, deflation will be a major economic topic.

(Joshua Barone and Eugene Hoover contributed to this blog)