Long & Short Banner

“Little by little. The wheels of your life have slowly fallen off“

Oasis, Little by little

Last week, we discussed the evolution of the global macroeconomic backdrop amid some more instances of stronger than expected US growth and inflation data. The US data again disappointed the doves, ourselves included, with yet another bump in the road. However, as we argued last week, we continue to see the data evolution as a series of bumps (not as a turning point upon which to extrapolate US - inflationary - demand growth) but maintain the view that continued disinflation and growth moderation will remain dominant.

As we also stated last week, we continue to see the configuration of supply and demand dynamics in the US as ultimately disinflationary. Indeed, this viewpoint remains consistent with the latest Fed minutes which noted that “almost all” participants judged it would be “appropriate to move policy to a less restrictive stance at some point this year.” but that they did not expect cuts to be appropriate “until they had gained greater confidence that inflation was moving sustainably toward 2 percent” and noted that “the recent data had not increased their confidence” in that regard.

With the path of monetary policy dependent on confidence - confidence that inflation is returning to target - we continue to argue that this is by default an asymmetric relationship. That the Fed has a default dovish, asymmetric reaction function with interest rates “deep into restrictive territory”. Some have recently questioned how restrictive monetary policy in the US is, given that current settings have not imparted the expected slowdown in growth. However, we have several thoughts on this.
Firstly, we are not convinced by the arguments that there has been any significant upward shift in the equilibrium rate of interest, or r* (and in many respects the argument is less relevant to the current macro date as it is unobservable especially when commentators talk of short term and long-term r*). A recent Fed paper reaches similar conclusions.

Secondly, this debate should be framed by the level of real rates, in that real rates have only been positive for a relatively short period of time - certainly a lot shorter than the period of time for which rates could have been deemed ‘restrictive’ or above equilibrium. Thus, the argument that the growth momentum has some immunity to the current level of nominal rates is likely premature.

Thirdly, the Fed mandate is to maintain price stability, the preferred barometer of which is PCE. However, if the Fed chose to look at inflation on a harmonised measure (HICP excluding housing and OER) such as the methodology used by the ECB, then core inflation in the US is currently 1.9% (a point recently made by Paul Krugman on X). The current level of divergence pricing between the US and European rate paths is not obviously consistent with the fact that on a harmonised basis US inflation is significantly below that of the eurozone. Indeed, even on the Fed’s preferred measure, the decline in inflation has been much smoother and more consistent (less bumpy) than the CPI.

And finally, it is important to consider the level of growth in relation to ‘potential growth’ in the context of policy restrictiveness. Productivity gains and significant supply side normalisation (a good example of which is the labour market normalisation we are seeing as a function of inward migration to the US) have likely pushed up the equilibrium growth rate, and thus recent growth data that has come in above expectations is less likely to be inflationary. Indeed, from our perspective, it is not sufficient to prevent further disinflation and thus ultimately policy normalisation - rate cuts. As we stated last week, ‘increased potential growth as a function of higher immigration and implied productivity gains are significant in relation to the Fed’s thinking - recent growth upgrades - but should also be important in relation to the market interpretation of the Fed’s reaction function’.

Thus, if inflation remains well behaved (and from a PCE perspective we would argue that inflation is already well behaved), then the bar for the Fed to normalise monetary policy is much lower than the current market pricing, from our perspective. This dovish asymmetric reaction function of the Fed is likely very important - especially given the recent sentiment swing - in relation to the June Fed meeting.

Finally, we would like to return to the last point we made last week - that the current consensus assumption is that the US economy will see higher growth, higher inflation and higher rates in the remainder of the year… this is a difficult triangle to square (so to speak). Especially if we consider that the recent ‘upside surprises’ to inflation have been supply driven (Oil/Gas prices, Insurance, Medical services) and thus likely constitute a tightening of consumer finances. This is particularly important in the context of recent conclusions by the Fed, that domestic savings in the US are almost exhausted. Something that is not consistent with higher demand growth.

For the first time this year it feels like markets are starting to question the strong growth narrative on the back of the increased likelihood of more protracted geopolitical tensions, weaker earnings in some instances and also on the back of the increasing difficulty of joining the inflation, rates, growth triangle against a higher baseline volatility on the back of higher uncertainties.

There is a famous Dornbusch quote that springs to mind given this nascent focus of the potential growth turndown and the market pricing of the Feds reaction function. “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could”. From our perspective this may well prove true of US interest rate cuts as the tightening of financial conditions and consumer finances continue to weigh on growth… Little by little.

Have you listened to Neil's podcast series?

Subscribe to our insights

If you are interested in our content, please sign up below and we will deliver Eurizon SLJ insights right to your inbox.

    I consent to my data being collected and stored for the purposes of providing me information regarding my enquiry and related services. If you have any questions about your data please contact us at research@eurizonslj.com

    Envelopes on a wood background

    This communication is issued by Eurizon SLJ Capital Limited (“ESLJ”), a private limited company registered in England (company number: 09775525) having its registered office at 90 Queen Street, London EC4N 1SA, United Kingdom. ESLJ is authorised and regulated by the Financial Conduct Authority (FRN: 736926). This communication is treated as a marketing communication intended for professional investors only and is provided only for information purposes. It has not been prepared in accordance with legal and regulatory requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. It does not constitute research on investment matters and should not be construed as containing any recommendation, advice or suggestion, implicit or explicit, with respect to any investment strategy or financial instruments, or the issuers of any financial instruments, or a solicitation, offer or financial promotion relating to any securities or investments. ESLJ and its affiliates do not assume any liability whatsoever for the contents of this communication, save to the extent agreed in any written contract entered into between ESLJ and the recipient, and do not make any representation or warranty as to the accuracy or completeness of any information contained in this communication. Views are accurate as at the time of publication. Opinions expressed by individuals are their own and do not necessarily reflect those of ESLJ or any of its affiliates. The value of any investment may change and an investor may not get back the original amount invested. Past performance is not an indicator of future performance. This communication may not be reproduced, redistributed or copied in whole or in part for any purpose. It may not be distributed in any jurisdiction where its distribution may be restricted by law and persons into whose possession this communication comes should inform themselves about, and observe, any such restrictions.