Three rate-cut questions for the Fed

2023-12-12 06:30:26

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Good morning. All quiet to start the trading week. With the holidays imminent, Unhedged’s idea hopper is running on empty. Help us replenish it: robert.armstrong@ft.com and ethan.wu@ft.com.

What we would ask Powell at Wednesday’s presser

Unless today’s inflation data is ferociously hot, the market consensus on a soft landing and 2024 interest rate cuts should remain intact. But even though some observers think the hard part is over, the Federal Reserve does not. Its job, in many ways, is harder now. In the words of chair Jay Powell, risks have become “more balanced”, Fedspeak for “the job market deteriorating is now a similarly scary prospect to inflation re-accelerating”. When inflation was running wild, smashing the higher-rates button with maximum vigour was the clear call. Now, more finesse is needed to secure the soft landing.

Signalling has a powerful impact on markets, so the Fed is understandably tight-lipped about how rates might fall, with one exception. As we discussed at the time, Fed governor Chris Waller said in late November:

If we see disinflation continuing for several more months — I don’t know how long that might be, three months, four months, five months . . . you could then start lowering the policy rate just because inflation’s lower . . . It has nothing to do with trying to save the economy. It is consistent with every policy rule. There is no reason to say we will keep it really high.

This sort of policy normalisation, lowering nominal rates to hold real rates steady as inflation falls, makes sense. But there are loads of questions around how it will work in practice. Here are three we are thinking about.

As inflation falls, what principles will guide policy normalisation? The Fed’s nightmare is stop-and-go rate increases reminiscent of the 1980s. That is the biggest reason to wait to normalise rates. In the milder case of the mid-1990s, the central bank cut rates after an uptick in unemployment, and eventually had to raise them again when the economy strengthened. In a note over the weekend, Morgan Stanley’s Seth Carpenter called that episode a “cautionary tale”. But equally, it is possible to put off cuts for too long, as the Fed did in 2007. Unemployment is non-linear; once it’s rising unambiguously, it’s often too late.

In a recent reportSkanda Amarnath and Preston Mui of Employ America offer three principles for rates normalisation: once cuts start, they should be front-loaded, proportional to inflation and data-dependent. Front-loading delivers a powerful dose of looser financial conditions right away, doing the most to counteract the risk of rising unemployment. Proportionality (eg, 1 per cent lower inflation rate = 1 per cent lower policy rates) gives the Fed and markets clear guidance for how fast to proceed. Lastly, data-dependence lets the central bank maintain optionality, in case inflation resurges or falls faster than expected.
What sort of inflation counts? Fed officials have said they want to see moderation in each of three inflation categories: goods, rents (the biggest category) and non-housing services. The reality of falling inflation and/or rising unemployment might change that. Prices of non-housing core services make up less than a quarter of the total inflation basket, and some, such as auto insurance, have been unusually, persistently hot. Would inflation in a few services categories keep the Fed from lowering rates even if unemployment was inching up and core inflation falling? Either way, “we have to have more clarity about what [types of inflation the Fed] is comfortable with”, says Kevin Gordon at Schwab.
Is it really full-steam QT for ever? Quantitative tightening (shrinking the Fed’s balance sheet) is a form of normalising monetary policy, Powell has said, meaning that rate cuts and QT could well go together. This has not always been the case. In 2019, while it was cutting rates, the Fed was forced to restart bond purchases because of chaos in the repo market. That came just months after Powell said QT was on “autopilot”. Some money-market watchers think the Fed will slow the pace of QT pre-emptively to buy itself time. Serious market dysfunction could kill off QT.

A recession could, too, or perhaps even a slowdown threatening to become a recession. Deutsche Bank’s US rates strategists argue that if the central bank is bent on “actively easing policy, it will end QT. This view is driven primarily by the communications challenges the Fed confronted in 2018-2019 around the prospect of having its two tools work at cross-purposes — that is, easing by cutting rates while tightening through balance sheet run-off”. In any case, we need a better sense of the Fed’s QT reaction function.

We’ll be keeping an ear out as Powell speaks on Wednesday. (Ethan Wu)

Are we in a profits recession?

A little while ago Bloomberg published a short piece which has stuck in my mind ever since. The article, “Without top five stocks, S&P 500 is deep into profits recession”, contained this passage:

Without its five largest names, the S&P 500’s quarterly EPS has fallen 1.5% in 3Q y/y, according to Bloomberg Intelligence — even with better than expected results. Compare that with the index’s overall growth rate of 4%

I was a little surprised by this, given how strong the economy was through the end of the third quarter. And it got me thinking about how much we should care if we are in a profits recession. The point of the Bloomberg piece, as I understood it, was that outside of the five biggest companies by market capitalisation (Apple, Microsoft, Amazon, Alphabet and Nvidia) S&P 500 profits are falling, and this should make us wonder about the sustainability of the current rally. But it also has implications for the economy: it likely reflects something about the ability of companies to raise prices, pay workers, invest in new projects and so on.

I did a little measuring myself, but differently from Bloomberg in two ways. First, I used sequential rather than year-over-year changes in earnings. I wanted to match the way we talk about economic recessions, for which the common narrow definition is two quarters of sequential declines in output. Sequential change is also a more immediate measure of economic momentum (though it does create the risk of seasonal distortion). And I also used net income, or more precisely net income adjusted for unusual items, rather than net earnings per share (my numbers come from S&P Capital IQ). I wanted to look past the effects of stock buybacks on EPS, so I could see changes in companies’ underlying profitability without the impact of changes to capital structures.

Looking in terms of sequential changes in net income, we are not in a profits recession, but we are close. While earnings fell 4 per cent in the third quarter, they rose 1 per cent in the second. Following Bloomberg, what about taking out the five biggest companies? That does appear to put us into a recession, with earnings growth down 8 per cent in the third quarter and 1 per cent in the second. But this, it turns out, is a distortion: in the third quarter, the eighth largest company in the index, Berkshire Hathaway, reported a big net loss because of changes to the value of its investment portfolio (Berkshire likes to put these changes aside when talking about its profitability). Take Berkshire and the top five companies out, and S&P earnings grew a plump 6 per cent in the third quarter; adjust for a large non-cash charge at Walmart, and growth is a point or two better still.

The data is fiddly, and there is not a canonical answer to the question “is US corporate profitability rising or falling?”. The closest thing is probably the national accounts compiled by the Bureau of Economic Analysis; these also show modest but positive sequential growth in profit after tax in the past few quarters.

That said, another way to see that we are not in a profits recession: only 68 companies in the S&P had profits fall sequentially in both of the past two quarters. The list of companies in “profit recession” contains companies from 10 of the 11 major sectors (communications services was the exception), but there was not an obvious or menacing macroeconomic pattern to be found in the list, other than a few sectoral trends (eg, transport companies are struggling; liability-sensitive regional banks are under margin pressure).

Profits, like the economy, are slowing. But we are not, however you slice it, in a profits recession.

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