WSJ Article from the Weekend - Plummeting Inflation Raises New Risk for Fed: Rising Real Interest Rates.

WSJ's Timiraos says the central bank feels pressure to cut interest rates as falling inflation raises the real cost of borrowing. 

"If inflation has sustainably returned to the Fed’s 2% target, then real rates—nominal rates adjusted for inflation—have risen and might be restricting economic activity too much".

This raises the question of when the Fed will cut, and by how much. Timiraos dismisses a cut at this week's FOMC, in fitting with analysts and market pricing, noting the Fed wants to be sure that core inflation can be sustained at or below their 2% target. He does note that Fed officials are likely to remove their tightening bias that rates are more likely to rise than fall, opening up the door to rate cuts in the coming months. Markets currently price in a c. 50% probability of a cut in March with a 25bp cut more than fully priced by May. The latest Fed poll found 86/123 economists expect the Fed to cut rates in Q2, with 55 looking for a cut in June and 31 expecting a cut in May. Throughout the year, markets price 135bps of cuts whereas 72/123 surveyed by Reuters see the Fed lowering rates by 100bps or less this year. 

Given inflation appears to be returning to target at a faster pace than the Fed had initially expected, and growth has remained firmer than expected, the Fed faces a tricky situation where strong growth could keep inflation sticky, but if it doesn't the Fed could over tighten and inflation would fall beneath their 2% target.  

The article writes that the Fed is mulling whether softening inflation means real interest rates will be unnecessarily restrictive if they do not act. 

The WSJ cites commentary from the Chief Economist at Point72 Asset Management, Dean Maki, said that the concerns that lower inflation will raise real rates are misplaced as it will boost purchasing power, consumer confidence, and spending. Also, citing a former Fed economist, William English, he notes that bond yields have fallen and stocks have risen, which could bolster economic activity and consumer spending, which could see officials wait until May or even later to cut. Although on the flip side, English said “if they get genuinely reassuring inflation numbers and the real economy seems to be slowing a bit, I could see them getting comfortable with a cut in March”.

Timiraos also cites commentary from Former Kansas City Fed President George, "We made a very aggressive tightening. Look not only at the supply that came back but also the demand that came down last year," , adding there is potentially a lot of room to cut rates before they are in neutral territory again. "Policymakers are right to worry that cutting rates then raising them again would blemish their credibility, said George. But she said the greater risk now is that taking too long to cut rates causes damage to the labor market that is hard to repair"

It is also worth noting that former Fed member Bullard, who was usually at one end of hawkish or dovish extremes when he was at the FOMC, gave an interview to the WSJ last week where he said he expects the Fed to start cutting rates in March, noting that inflation on a 12-month core basis, could get to 2% by Q3 24. He also suggested if inflation is somewhere between 2-2.5%, and rates still have not been cut, the Fed may have to move very aggressively. 

On real interest rates, both Fed Chair Powell and Governor Waller have both spoken on it. Waller stated that the healthy state of the economy provides the flexibility to lower the (nominal) policy rate to keep the real policy rate at an appropriate level of tightness. Waller did stress that rate cuts should be carefully calibrated and not rushed, adding there is no reason to cut as quickly in the past. Fed Chair Powell at the December press conference, stated the Fed is very conscious of real rates and that it is a part of how the Fed thinks about things, but his expectation would be that the real rates decline as the Fed moves forwards. 

Please click here for the WSJ article.

Analysis details (13:05)

• Note, this piece summarises some key points from WSJ Timiraos' article released on the weekend, with some commentary added by Newsquawk.

29 Jan 2024 - 13:05- Fixed IncomeResearch Sheet- Source: WSJ/Newsquawk