Money Matters – 8 May 2024

Guy Foster, Chief Strategist and Janet Mui, Head of Market Analysis, discuss a range of U.S. financial data, including the forecast for interest rates, fresh jobs data, and financial conditions impacting monetary policy.

Last week, investors’ interest was drawn to two beacons, Wednesday’s decision on interest rates by the Federal Reserve (the “Fed”), and the health of the labour market.

The new norm for interest rates?

Firstly, interest rates, and it came as no surprise that they remained unchanged for the sixth meeting in a row, by virtue of which the upper threshold of the U.S. Federal Funds rate has remained at 5.5% for over nine months.

A major topic of this year has been the disconnect between the economy and expectations of interest rate movements. For some reason, investors were very confident that rates would fall this year, and I have discussed in previous weekly round-ups that this expectation seems at odds with the available evidence. So, why did investors believe it? There are a few connected reasons:

  • Monetary policy operates with long and variable lags, so just because the economy is doing well now, doesn’t mean it won’t be doing badly soon.
  • The Fed has raised interest rates to a level it believes should slow the economy down.
  • Historically, attempts to do this have tended to go too far.
  • While interest rates often fall and stay low for long periods of time, they rarely rise and stay high for very long.

 

Speculation that interest rates could stay higher for longer has been rife over the last year or so. While it was discussed a lot, economists’ forecasts and market positioning made it clear that the general belief was in interest rates that followed a historical precedent of a rapid decline from a short-lived peak.

However, lately that view has been challenged. Speculation has moved from interest rate cuts starting by March this year to there being no rate cuts at all in 2024; more recently, some have even suggested the next move in interest rates might be upward.

Where are expectations now?

The consensus is still for interest rates to fall by a quarter to a half percentage point by Christmas this year. Last week offered an opportunity to hear from Fed chairman Jay Powell whether his conviction that rates would fall was wavering, and it is to some extent. Powell believes that gaining the confidence to cut rates will take longer than previously expected.

Why? Well, partly because interest rate cuts have had relatively little effect on the household sector. The very low interest rates during the pandemic allowed most U.S. homeowners to lock in very low mortgage rates, such that there has been minimal impact on aggregate consumer debt service costs.

Beyond interest rates

Sometimes, monetary policy is measured through a broader concept of financial conditions rather than just through interest rates. That includes such things as the level of the stock market (which makes people feel wealthier), or the cost of new borrowing for individuals and companies.

Financial conditions have been loose due to the strong performance of the stock market, and the Fed’s conviction that it will be cutting policy rates has pre-emptively caused a decline in market interest rates.

In the background, inflation has remained higher than had been expected. Some of that has to do with core inflation and reflects a labour market that is still strong and house prices that are more resilient than predicted. Headline inflation has also been driven higher by gasoline prices. Right now, some of these forces are turning. Gasoline prices have been easing back as the situation in the Middle East shows signs of stability, and connected to that, inflation arising from supply chains has slowed.

The jobs market

The main focus, though, must be on the labour market.

Typically, the labour market responds to a weak economy, so by the time the central bank sees a rise in the unemployment rate, that increase has often developed enough momentum to trigger a recession.

And with that, focus has been on labour market data from last week. Earlier, the very lagged data on job openings suggested the medium-term trend of declining job openings remains in place. We have also seen a decline in the number of people who are voluntarily leaving their jobs – job quitters often achieve higher compensation, so a high quit-rate suggests inflation may be high.

Last week’s monthly labour market report for the U.S. had some very encouraging news for investors. Although new jobs were created, the pace has slowed. The unemployment rate edged up, but only slightly, while wage growth slowed slightly. Everything about the report exuded a sense of controlled descent.

What’s next?

Looking forward, the question is firstly whether this month’s data is noise, and strength will recur next month. That seems unlikely given many of these trends were already in place.

So, if this trend intensifies, could this mean an economy that decelerates or contracts in the run-up to the election? Or can the economy maintain its state of grace, slowing towards target without triggering a recession?

That might seem far-fetched but in support of the latter, more optimistic scenario, the nine months that interest rates have spent unchanged (after a series of rate hikes) is a relatively long time. It’s similar to the year that rates spent unchanged before the financial crisis.

Other than that, it’s almost unprecedented. In the mid-90s,  there was a period in which interest rates declined before being reasonably stable for around four years. And these periods of stability seemed to congregate around interest rates of between 5% and 5.5%.

The timing is of interest because the beginning of the 90s ushered in a new era of inflation targeting by central banks, which led to remarkable stability in interest rates.

There are some very valid observations that this period was unusually easy because it coincided with globalisation and the onset of the internet – which conspired to reduce inflationary pressure. Perhaps to some extent, central bankers, who have had a torrid time over the last few years, can claim they are getting to grips with the art of monetary policy and not just lurching from crisis to crisis, as it sometimes feels.

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