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Komal Sri-Kumar: What Will Cause Rate Cuts

Good Inflation News This Week Not Sufficient. There was good news on the inflation front on Wednesday. Data released by the US Bureau of Labor Statistics indicated that headline consumer prices were unchanged last month following a 0.3% rise in April. That data-point, and the slowing of the core inflation measure (which excludes food and energy) from 0.3% to 0.2%, provided the impetus for a rally in equities and Treasurys. The change in direction from the upturn in the various inflation measures in the first quarter gave rise to renewed hope of a cut in the Federal Funds rate by September.

The Federal Open Market Committee put a dent on the euphoria. The median forecast by FOMC members was for just one rate cut during the rest of the year. In announcing its "dot plot" for future interest rates, the FOMC downshifted from its projection at the March meeting that there would be three rate cuts during 2024. In the past, news on the May inflation measures would have given rise to a dot plot suggesting the imminence of a rate reduction and the expected rate path shifting downward during the rest of the year and in 2025.

The bigger surprise came from Chairman Jerome Powell who has, more than once, belittled the importance of the dot plot at past press conferences by stressing that the dot plot did not mirror the view of the Federal Reserve but represented individual members' forecasts. This time around, he stuck close to the FOMC announcement and suggested that the Federal Funds rate would not be lowered until the Fed was confident that its 2% inflation goal was within reach. "So far this year, the data have not given us that greater confidence," he said in his prepared remarks on Wednesday.

Why did Powell deviate from his past practice of providing a more dovish outlook at his press conference compared with the collective FOMC view? The explanation is that he was bitten more than once and that should lead him to being several times shy! For example, having indicated in December that "we believe that we are likely at or near the peak rate for this cycle," he found the resulting rally in risk asset valuations made his job of inflation mitigation that much more difficult. The improvement in the price situation in the second half of 2023 was partially undone by the upturn in inflation during the first quarter of 2024.

Put differently, Powell is gradually learning that winning the war against inflation requires him not to exult over successes in individual battles. Premature claims of victory sow their own seeds of defeat. What does the improvement in the consumer price inflation released on Wednesday, and a similar downward move in producer price inflation on Thursday, imply for the actual path of interest rates?

I have indicated in past SriKonomics issues that the massive amount of liquidity that the Fed created during 2020 - 2022, and the concomitant surge in the federal fiscal deficit, mean that inflation is going to continue to be sticky in the downward direction. Even the single rate cut during the year that the median FOMC forecast signaled on Wednesday may be difficult to achieve based on price data alone.

And the central bank cannot ease policy hoping that the cumulative impact of rate hikes through July 2023 will suffice to lower inflation to 2%. Why? Because past Powell statements that inflation is on a steady path down have not been supported by empirical evidence. If he had cheerled markets on Wednesday by saying that inflation had been beaten, the collective market reaction would have been the equivalent of "Haven't we seen this movie before – not just once but several times?!"

In looking for a factor leading to an easing of Fed policy, we could look at the second part of the Fed mandate – maintaining stable growth and employment. The latest nonfarm payroll report showed the economy generating 272,000 jobs in May, far higher than the consensus had anticipated. Average hourly earnings rose by 4.1%, too rapid to be consistent with bringing inflation down to target. Therefore, this portion of the Fed mandate would also not provide support for a rate cut.

In locating a source for rate cuts, I would not look at the US economy in its entirety but at parts of it that have been especially hit by the volatility in Treasury yields over the past four years. Although two- and 10-year Treasurys rallied last week based on optimism that odds of a rate cut at the September meeting of the FOMC had increased, the yields are still too high relative to those at which financial institutions bought long-dated Treasurys in 2020 and 2021.

Financial institutions loaded up on 10-year Treasurys, for example, during calendar year 2021 at yields between 1% and 1.5%. After all, the Chairman had said repeatedly that the pickup in inflation had resulted from supply bottlenecks and was "transitory." Did it not make sense to seek capital gains from eventually lower yields on long-dated securities? Of course, we all know that yields went the other way. Even after the rally in Treasurys brought the yield down by 23 basis points last week to 4.23%, the loss on the banks' holdings is substantial – partly hidden through a process known as "holding assets to maturity." This means that the securities do not have to be marked down to where they trade in the market. The persistence of a high Federal Funds rate is likely to provoke more deposit outflows from weaker institutions as they did in March 2023.

It will also keep the risk elevated in Commercial Real Estate. According to the Mortgage Bankers Association, $929 billion of CRE loans held by banks and investors will mature in 2024. This is the equivalent of 20% of the total outstanding, and up 28% from the amount due in 2023. The large increase this year is because loans that were not repaid on time last year were rolled over and have become due in 2024.

A breakout in either area – rather than benign inflation numbers – is likely to be the factor leading to a lower Federal Funds rate. In short, watch for a "credit event."

Dr. Komal Sri-Kumar


Sri-Kumar Global Strategies, Inc.

Santa Monica, California

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Posted: June 14, 2024 Friday 05:34 PM