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“... one step closer to the edge and I'm about to break“

LInkin Park, One Step Closer

Happy New Year.

As we start 2023, the themes that dominate the macroeconomic debate are familiar: how inflation, monetary policy and growth interact going forward; how China's reopening momentum balances global demand growth (and commodity demand) in 2023, and; how global geopolitical developments shape macroeconomic factors. However, we would argue that the nuance or emphasis in these debates have changed. Today, following a series of important data prints in the US, we focus on the first theme - inflation, monetary policy and growth.

In our last piece in 2022, we highlighted our rising confidence that the Fed is closer to the end of its rate hike cycle - despite market pricing to the contrary - suggesting that 25 and done for the Fed in 2023 was an increasingly likely prospect. “As inflation falls…through 2023, front end real rates are going to become even more restrictive. Thus, … the rate at which the Fed may consider “sufficiently restrictive” also falls. I would certainly not rule out the possibility that the March FOMC meeting (after a 25bp hike in Feb), will be unchanged as new projections highlight the lower inflation and demand profiles!”

The concept of the Fed hiking 25bps at the Jan 31st/Feb 1st meeting and not going any higher is certainly still at the dovish end of market expectations. However, the progression of the data in the first week of 2023 highlights that this scenario is perhaps not as much of an outlier as the markets may have thought. We have discussed, on a number of occasions in 2022, our views that US demand (although this likely applies elsewhere equally - UK in particular) will likely respond in a non-linear manner in relation to future rate rises. In essence we see two dominant factors in this assertion: Firstly, the significant demand boost from massive (Covid) fiscal stimulus has undoubtedly had a huge impact on demand and thus prices. However, the stimulus is finite and household savings have been diminished by higher prices and now a significantly higher cost of money. Thus, going forward demand is likely non-linear in relation to future rate rises.

Secondly, central bankers often discuss the ‘long and variable’ lags of monetary policy on demand. Nowhere is this more dominant than in relation to mortgage debt and housing demand on consumer demand. Over recent years demand has also been supported by a huge monetary stimulus (ultra-low interest rates in response to the Covid shock), that has driven property prices sharply higher. What we are seeing now is a reversal of the monetary impulse as rates move deeper into restrictive territory, and house prices are turning lower. It is likely that the negative wealth effect of lower property prices against a sharply higher cost of money has a non-linear negative impact on demand going forward too. By extension, lower property prices are likely to have a disproportionate or asymmetric impact on inflation going forward.

A recent Fed paper that highlights the asymmetry between negative shocks and positive shocks on demand (consumption reacts to bad news but not to good news) suggests that perhaps non-linearity of future demand is a part of the Fed debate. For us this means that 25bps is the likely Federal Open Market Committee (FOMC) decision for February as the Fed “Feel” their way to “sufficiently restrictive”.

Moreover, there were two further pieces of economic data that have defined the price action across macro markets so far in 2023. Data that we feel could retrospectively be viewed as a significant milestone in the evolution of sentiment - and ultimately policy - in 2023. They are also worthy of comment in the current debate.

(i) The US employment report for December highlighted an impressive drop in average hourly earnings a sign that the labour market is (finally) cooling. This in and of itself should bring comfort to the Fed. Job gains rose further(even to the degree that there was some closing of the gap between the household and establishment surveys - towards the significantly higher establishment survey), however labour participation (or labour supply) was up set against a continued fall in job openings (demand for labour). Meaning that thus, far the cooling of the labour market, or reduced relative demand for labour has come as a function of lower job openings and not higher unemployment.

(ii) The second notable data print is the December Services ISM, which showed a substantial drop in the headline (following the manufacturing sector into contractionary territory - for the first contractionary print in a decade outside of the covid distortions of 2020). New orders were particularly weak and outside of the fact that one data print should not be overemphasised in isolation, the prospect of contraction in the dominant sector (~80%) of the US economy will undoubtedly raise concern at the Fed.

The CPI this week was interesting. It is possible that in the very short-term markets this may have been a little over-positioned in respect to the ‘dayweight’ or the expected impact of the Dec CPI print in isolation. Indeed, there was a significant concentration of top-tier bank analysts that were forecasting an even lower print than the average. The breakdown of the data show two more very important factors. Firstly, that the most recent prints are decelerating rapidly (the 3m annualised core inflation is running at just 3.14% in the December data - the lowest level in 15 months). Secondly, if we look at the three components of inflation that the Chair of the Fed outlined in November (a) core goods, (b) housing services and (c) non housing services - only shelter remains elevated on a 3m annualised basis (this is likely both lagged and technical - high frequency alternative data suggest significant slowing in property markets. The component that the Fed’s Chair said was the key focus of the Fed - non-housing services is running at just 1.2% (3m ann.). Thus, taking a step back from the intraday price action, the moderation of inflation in the US is substantial. In conjunction with the cooling in the labour market and the slowing in economic activity, it is also in our view policy relevant.

Over recent months, the ‘global’ debate over inflation has also evolved. As clear signs of resolved supply chain blockages, and even normalisation of price pressures in global manufactured goods markets, the debate evolved to centre on the energy complex and the implications for energy driven inflation. Again, this time predominantly a function of moderate winter weather across the globe, energy prices have also moderated sharply. Thus, while we expect the US inflation progression to be front and centre for the global macroeconomic debate the prospect of Central Banks undershooting market tightening expectations also clearly applies to the European Central Bank (ECB) (where markets expect almost another 150bps of hikes by the Summer) and the BoE (where markets expect another 100bps but I would personally be in the Tenreyro/Dhingra camp that current rates are high enough!)

It is perhaps not surprising then that the tone from the Fed speakers has been (admittedly subtly) amended. Headline writers were keen to label comments from San Francisco Fed’s Daly and Atlanta Fed’s Bostic as Hawkish in respect of their reiterated expectations of a 5-5.25% terminal rate that remains in place for a year. This is not a hawkish progression, this is simply Fed members being consistent with the most recent FOMC meeting message. From my perspective it was the emphasis on the data dependence of the Fed, with regard to policy going forward that was the most revealing. Dovish, not hawkish. Indeed, following the CPI print Philadelphia Fed’s Harker noted that “25bps hikes will be appropriate going forward”. When the data changes, Fed policy can change. Perhaps much quicker than the market expects - 2023 so far has brought data, that from my perspective, move the Fed one step closer to the edge… one step closer to 25 and done.

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