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“Must be the best place in the world“

Wolf Alice, Beautifully Unconventional

Last week, we discussed our continued view that it is the growth/inflation tradeoff that remains the critical piece of the current macro puzzle and also that the evolution of the data (upon which the central banks are audibly dependent) has been noisy but in our view, still consistent with continued disinflation and growth moderation.

We argued that the market continues to need corroboration from the data to re-engage in the monetary normalisation trade (especially at the front end, where the pullback at the start of the year likely hurt many participants); clearer data moderation is a necessary precondition for DM rate cuts. Indeed, a strong case could be made that recent data has revealed weakness in factory orders (Jan), ISM services (Feb) - especially in relation to prices and employment - activity moderation, and even the February employment report. However, we also argued that the CPI and PPI added more noise to the debate, ticking up at the headline level to 3.2% y/y in February after an upside surprise (distorted by ‘January and one-off effects), even if the Fed’s preferred measure (Core PCE) has been much better behaved and traces a smoother disinflationary path.

Against this noise and uncertainty about the interpolation or extrapolation of growth and inflation trends, the Fed narrative was thus critical. We will come to that shortly. First, a raft of other Central Banks deserve a mention this week.

First up was the RBA. The RBA left the cash rate on hold at 4.35% in March, as widely expected. Beneath the stability on the surface, however, the monetary policy reaction function remains complex, as inward immigration has boosted domestic demand in specific areas - notably housing (while normalising the labour market and thus bringing wage gains back to a level consistent with inflation at target). At the consumption level, the RBA noted that household consumption remains ‘particularly weak’, and while this should accelerate disinflation going forward, supply-side constraints such as weak productivity and high unit labour costs likely slow the normalisation. From our perspective the RBA path is likely to converge towards other DM rate cuts for H2 2024 and beyond.

In quick succession came the BoJ. The Bank of Japan raised rates for the first time since 2007 this week - removing their negative interest rate policy (NIRP) and at the same time, scrapping the Yield Curve Control (YCC) policy aimed at limiting term yields through (unlimited) bond purchases. Governor Ueda made it very clear that the spring wage results (a significant rise in negotiated wage deals) were a major factor in the decision - going a long way to confirm the virtuous link between wages and prices and thus the end of more than two decades of deflation.

The Swiss National Bank was the big surprise in the DM space, with a 25bp cut to 1.50%. Headline inflation in Switzerland, having peaked at just 3.5% y/y (substantially lower than its European counterparts), has declined sharply since the second quarter of 2023 and fell below the top end of the 0-2% target in June ’22. Further declines (to 1.2% y/y) in 2024 and “substantial” downward revisions to the conditional inflation projections (to just 1.1% at the forecast horizon) from the SNB – interestingly now driven by domestic services disinflation - drove the decision to act ahead of market expectations. The SNB Statement stated that the fight against inflation had been successful and that they were willing to be active in the currency markets if needed.

The Bank of England left interest rates unchanged at 5.25% as expected this week, but in the broader scheme of a dovish shift in DM (with the obvious exception of Japan) the tone of the statement was notably dovish. Firstly, the vote split evolved from 2:6:1 (2 dissents for a hike and 1 dissent in favour of a cut) at the February meeting to an 8:1 vote this week (1 dissent in favour of a 25bp cut). While markets had retained a more hawkish view over recent months based on expectations of more sticky inflation (on goods and labour supply inefficiencies - post Brexit), our view remains that the underlying growth is weaker than the headline data suggests and thus disinflation and growth moderation will remain dominant and drive a more dovish response from the BoE. Possibly even one which accelerates in the second half of 2024.

Following the BoE meeting, Governor Bailey re-emphasised the new dovish bias of the MPC - essentially on the basis of the failure of upside second round inflation risks to materialise - and stressed that every meeting is now ‘live’ and that the MPC do not need to see inflation drop to 2% before cutting rates.

While all of the central bank activity this week is interesting, the monetary policy path of the Fed remains the dominant global macro factor at the current juncture. Thus, it is right that the FOMC takes the dominant place in the narrative. Above, we reference our previous thoughts on the evolution of the US data and the Fed reaction function. Ultimately suggesting that while there have been many data series in the US that have indicated further disinflation and growth moderation, the most recent inflation data (while likely distorted for seasonal and one-off effects) has been noisy and thus not sufficient to provide “further confidence” that inflation is returning to target. Despite this, at the semi-annual testimony to congress Powell stated the Fed are “not far from the level of conviction needed to begin dialling back the level of restrictiveness of monetary policy”.

The Fed this week left rates unchanged at 5.25% - 5.50%, with modest changes to the statement. However, it was the Summary of Economic Projections (SEP’s) and the ‘dots’ that grabbed the headlines. Notably, the Fed raised growth projections throughout the forecast horizon with GDP revised up to 2.1% this year, from 1.4% and up to 2.0% in 2025 and 2026, and inflation projections (Core PCE) up 2-tenths this year and 1-tenth next year. All this while maintaining the ‘Median dot’ for 3 rate cuts in 2024.

Some commentators have suggested that this is a Fed that is comfortable running inflation above target and, by extrapolation, sees a steeper yield curve and a positive risk asset trajectory. For us, however, this is likely a further reaffirmation of the asymmetric dovish reaction function of the Fed against an increasingly high bar for the data. Indeed, with the current unemployment rate at 3.9%, even if this is distorted by the household survey’s inability to effectively capture the recent significant inward immigration, it would only take a modest rise (not unthinkable given the tight financial conditions and recent clear signs of deflating labour market tightness through Jolts, quits and even ISM data). US growth consistently above the equilibrium growth rate for the entirety of the forecast horizon - effectively a ‘no landing’ scenario - is, in our view, unlikely. Furthermore, the Fed’s ‘upgrading’ of the inflation path gives them a little more room to withstand the ‘noise’ at the start of the year and for the evolution to still be consistent with Fed forecasts - even with a rate-cutting cycle starting in June.

Our underlying macro view remains that further disinflation and growth moderation will be dominant and that with the FFR well into restrictive territory, the Fed’s reaction function will be asymmetric (dovish). From our perspective, the updated SEP’s and dots reaffirm, or even exacerbate this prospect. Powell was not only clear that it will be “appropriate to begin easing ‘at some point this year’”, but also that he believes that the policy rate is likely at the peak for the cycle.

Overall, it has been a very busy week for central banks (and we haven’t even mentioned the 12.5bp hike from Taiwan, the 50bp cuts from Brazil and Czechia, or the 500bp hike from Turkey!). The Fed may have revised up their projections for growth and inflation (now seeing above-trend growth throughout the forecast horizon, but for us the dominant theme remains disinflation and growth moderation. Indeed, the broad DM central bank evolution this week has been clearly dovish - as inflation trends are predominantly global, this is perhaps not surprising. On this basis, it is the US that is the outlier. However, rather than extrapolate this view as US exceptionalism, we are more inclined to see this as a temporary or even anomalous divergence (even if huge US fiscal can account for some of the difference). Going forward, while we maintain the view that the monetary reaction function of the Fed is asymmetrically biased to the downside, weakening in the official data is a necessary precondition for action.

To paraphrase Wolf Alice, the market is currently viewing the US as “the best place in the world” from an economic standpoint (or at least the DM markets). But “You know, nothing is what it seems” and from our perspective, the US remains a “walking contradiction”!

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