Why Fed Easing May Come Sooner Than Markets Think (March 24, 2024)

A deliberately dovish Powell suggests debt-servicing costs, bank solvency concerns and economic cracks outweigh renewed and still-elevated inflation

By Lisa Beilfuss

Federal Reserve Chairman Jerome Powell’s March press conference was decidedly dovish. Yet markets may still be underestimating the central bank’s easy-money bias.

In his post-policy meeting remarks and Q&A session with reporters, Powell downplayed the renewed rise in inflation this year, signaled a tapering of balance-sheet runoff would start much earlier than markets expected, and described financial conditions as restrictive. That is despite signs the inflation upswing isn’t simply seasonal and evidence financial conditions aren’t actually tight, with stocks at all-time highs and crypto “meme coins” quickly minting millionaires. What is more, the messaging came after hot January and February inflation numbers had already led Wall Street to embrace a higher-for-longer policy scenario.

“Powell had all the possibility in the world to simply repeat the slightly hawkish stance of the FOMC press release. He actively chose not to,” says newsletter writer and former hedge fund manager, Florian Kronawitter. 

The dovish messaging wasn’t an accident. Powell tipped off investors on two counts. First, the inflation target is now something above 2%, with Powell saying eight times during his press conference that a return to 2% will happen “over time.” 

Second, the Fed’s asymmetric dual mandate means it won’t take much weakness to spur policy easing, and signs are already present for those interested in looking. That point may seem to conflict with both rising inflation and the Fed’s own updated economic forecasts. But cracks are present not just alongside but because of renewed pricing pressure. Consider the latest small-business survey from the National Federation of Independent Business. Inflation returned as the single most important problem reported by respondents, while small-business owners said they plan to hire at the lowest level since May 2020.  

As for the Fed’s revised economic projections, it raised GDP estimates through 2026. But higher growth estimates effectively lower the bar for the Fed to ease more than the expected three rate cuts this year. It is also possible that such forecasts reflect Fed expectations for more fiscal spending, in the face of economic distress or otherwise. 

Powell’s deliberately dovish messaging shouldn’t be fully ascribed to election-year politics. Bigger picture, though, government debt-servicing costs are a practical constraint. Federal interest payments rose to $1.03 trillion in the fourth quarter, up 24% from a year earlier and up 82% from the end of 2020, before massive pandemic spending and Fed rate hikes. That represents a record 3.8% of U.S. GDP. It is more than the U.S. spent on Medicaid in fiscal 2023, and it is close to surpassing the $1.13 trillion spent on national defense and veterans over the same time frame. 

If Washington is unlikely to aggressively cut spending or raise taxes, interest rates must fall or debt-servicing costs will eat away at discretionary spending–the very business of politicians.

That isn’t to mention hundreds of billions of dollars in unrealized losses on banks’ balance sheets due to the rapid rise in rates. Kansas City Fed researchers said in an October report that the situation has many banks close to insolvent. They essentially concluded that the banking system needs an economic slowdown insofar as lower interest rates are necessary to boost securities valuations. 

A Fed that wants an offramp may already have more cover than many strategists appreciate. Consider recent news out of California’s nonpartisan Legislative Analyst’s Office, citing data from the Bureau of Labor Statistics. The state added only 50,000 jobs last year, down an extraordinary 85% from initial reports. Here are two reasons this matters: California represents 12% of the civilian workforce in the U.S., and the massive revision underlines the trend in downward revisions to monthly nationwide nonfarm payrolls numbers. 

The Philadelphia Fed has separately suggested national payroll growth is much lower than originally reported by the Labor Department, where low and falling survey response rates are one reason monthly data have been plagued with big downward revisions. The Philadelphia Fed’s work to reconcile state-level data suggests a downward revision of at least 800,000 jobs for the 2023 fiscal year ended in September. 

“This suggests that the Fed is skeptical of the mainstream media's narrative that the private sector is robust, a signal that seems to have been overlooked by Wall Street,” says James Thorne, chief market strategist at Wellington-Altus.  

It is probably no coincidence, then, that in his latest appearance Powell four times mentioned “unexpected” intermeeting events or labor market weakness could spur earlier rate cuts. Bloomberg economist Anna Wong described such comments as “strange,” and she notes that the low 4% Fed estimate for unemployment this year means it is “quite easy” to get “unexpected” conditions.

There is an additional, if counterintuitive, reason to bet on a more dovish-than-expected Fed. A February paper authored by a team of economists including former Treasury Secretary Larry Summers set out to square seemingly robust economic data with depressed consumer sentiment. The paper notes the cost of money is no longer included in traditional price indexes, creating a gap between the measures favored by economists and the effective costs borne by consumers.

The economists present alternative CPI measures that reflect mortgage interest payments, lease prices for vehicles, and personal interest payments for car loans and other non-housing consumption. When interest paid is considered as a cost borne by consumers and included in the CPI–as was the case before the index’s 1983 redesign–inflation had a much higher peak and continues to rise at a high level. The authors say their alternative measure suggests headline CPI peaked at an 18% annual rate in November 2022 and still stood at about 9% in November 2023, triple the CPI’s rate. 

One interpretation: Debt-servicing isn’t just an issue for the government, and relatively high interest rates themselves are pushing up household inflation.

Many analysts predict the Fed won’t ease until summer 2024 or beyond–unless something “breaks,” the vague expectation that it will take severe financial-market or economic turmoil to trigger early and swift rate cuts. But it may not take so much trouble this time. Unsustainable debt-servicing costs and losses in banks’ bond portfolios, in combination with weakness in secondary economic data, mean it is possible investors are underestimating the central bank’s dovish disposition and willingness to ease.