Powell’s Pivot Isn’t About a Soft Landing (December 18, 2023)

Whether the Fed’s flip is about U.S. debt sustainability or something else, the upshot is inflation that remains stubborn and is likely resurgent 

By Lisa Beilfuss

The motivation behind Fed Chairman Jerome Powell’s apparent pivot, surprising both in its timing and aplomb, is unclear. What is clear: The central bank is effectively abandoning its 2% inflation target.

The ostensible rationale for Powell’s dovish turn–sticking a soft landing–is unconvincing because such an outcome would be fleeting at best. Whether the pivot is about systemic stress, U.S. debt sustainability, or plain election-year politics, investors should enjoy broad market gains for now. So too should they prepare for inflation that remains elevated and is potentially resurgent.

In a note to clients following Wednesday’s Fed policy meeting and Powell’s press conference, MUFG head of U.S. macro strategy George Goncalves addressed the elephant in the room: “Do they know something that we do not know?” It is an obvious question given Fedspeak and upside economic data leading up to the latest decision. What is more, U.S. financial conditions are the most accommodative since the Fed started lifting rates last year, according to the Bloomberg U.S. Financial Conditions index, and Powell seemed unbothered by the effective unwinding of his tightening campaign. 

First the good news. Policy accommodation tends to lift most boats, says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. At least in the short term, she says equity returns are apt to broaden as the Fed’s pivot supports a material rotation away from mega-cap secular growth stocks to cyclical and value-style names and large- and small and mid-cap stocks.The U.S. dollar’s decline meanwhile supports a resurgence of non-U.S. stocks, especially in emerging markets, while falling rates sustain bonds of all stripes, Shalett says.

There is more good news, depending on how one sees it. Pimco economists Tiffany Wilding and Allison Boxer say an analysis of 140 central bank rate-cutting cycles across 14 developed markets from the 1960s to today shows that central banks tend to cut more aggressively than markets initially expect. That partly reflects the difficulty forecasters have in anticipating recessions–and the tendency of central banks to not cut until they are confident the economy has entered recession.

Even in the handful of instances central banks have cut absent recession, they still delivered an average 200 basis points of cuts in the first year, Wilding and Boxer say. That is twice the pace of cuts signaled in the Fed’s latest Summary of Economic Projections, meaning market expectations for six cuts next year may not be unreasonable.

But, as Shalett warns, “euphoria feels good in the moment but may come at a price.” The price, of course, is higher prices. 

Consider the so-called supercore measure of inflation emphasized by Powell himself. The metric excludes rental and owner-occupied housing, and it is stuck around 4%--double the Fed’s annual target. The Fed has suggested wages are behind the hot supercore readings and that the threat is over because immigration is boosting labor supply.

That optimism seems misplaced. Average hourly earnings recently reaccelerated in November to a monthly pace of 0.4% and rose 4% from a year earlier. The Atlanta Fed’s wage-growth tracker rose 5.2% in the latest month, matching the previous gain, as pay for job switchers sped up to a 5.7% pace. The University of Michigan’s sentiment survey shows consumers see year-ahead inflation above 4%. 

That isn’t to mention the money supply. Despite the reversal in M2’s rate of growth, money supply in the system continues to run at roughly $3.5 to $4.0 trillion, implying inflationary threats, says Shalett. Nor is it to mention key long-term drivers of inflation–expectations, currency weakness and labor activism–what Vincent Deluard of StoneX says are all stronger than they were at the 2022 inflation peak.

Underpinning the idea that wage inflation isn’t over, Bleakley Financial Group chief investment officer Peter Boockvar points to ABM Industries, a large provider of services from janitorial work to landscape maintenance. On its earnings call last week, executives said labor-cost inflation would rise 4% to 5% in 2024. Connecting the dots between higher wages and higher overall consumer prices, ABM executives said they expect to recover two-thirds of their higher labor costs via price hikes. 

Given all that, the question from MUFG’s Goncalves–what does the Fed know that we don’t–seems more salient. There are several possible explanations for the Fed’s pivot. Here are two.

The first is that the Fed is worried about the availability of credit. A quick scan of Powell’s calendar shows a series of recent phone calls with bank CEOs, including Jamie Dimon of JP Morgan, James Gorman of Morgan Stanley, David Solomon of Goldman Sachs, Brian Moynihan of Bank of America, and John Turner of Regions Financial. 

A Fed chair speaking with bank CEOs isn’t unusual. But the timing and volume of the calls come as credit growth slows. Nancy Lazar of Piper Sandler notes that despite assumptions to the contrary, private credit growth isn’t offsetting weakening bank loan growth to support business spending.

More likely: Powell’s about face is about the struggles of Treasury Secretary Yellen and the conundrum of U.S. debt sustainability. Shalett notes that interest costs on the debt, now close to 125% of GDP, are on pace to approach 60% of discretionary spending by 2030. 

“We are concerned that the central bank may be going beyond its mandate in order to address U.S. debt sustainability and enable the Treasury to issue long bonds below 4%,” Shalett says, calling third-quarter Treasury issuance “disastrous” and noting that financing has since been dominated by bill issuance and largely funded by swelling money market funds. 

“That game has a short shelf life,” Shalett says. “This strategy—essentially echoing Modern Monetary Theory—may yet be long-run inflationary and extremely damaging to the U.S. dollar.”

The Fed’s recent pivot isn’t about executing a soft landing. Inflation data and inflation expectations across households and businesses don’t, at this point, allow for that to be a valid explanation. Whatever the true reason for the abrupt turn, investors should plan for a prolonged stretch of above-target inflation–even if recession unfolds.