Liar Liar

Life Is No Bed of Tulips

Here we go, with life imitating art again. The Federal Open Market Committee (FOMC) did its best to imitate Jim Carrey in Liar Liar, a movie where he was cursed to speak the truth. The central bank went to great lengths since the election to convince us that it was ignoring the inflationary potential of Trump’s policies. Powell went as far as to say, “The decisions we are making right now are not about…[trade and immigration]...they’re about what is happening in the economy right now.”

Then, on Wednesday, the FOMC channeled George Washington and could not tell a lie. We were told the Fed is, in truth, actually concerned over inflationary risks from tariffs and immigration. Still, at risk of having his nose grow at the press conference, Powell said that “some” of the Federal Open Market Committee (FOMC) members had factored in the next administration’s policies into their forecasts. However, the facts are that as of September’s Summary of Economic Projections (SEP) only 3 of the 19 FOMC members were concerned about upside inflation risks, but in December, there were 15 out of 19 members who worried. We think 15 is more than “some”.

The consequences are twofold:

• The FOMC has transitioned to being an inflation fighter. The market was quite comfortable expecting steady rate cuts next year, yet this about-face has the market expecting at most one cut by December 2025. Implication: long-maturity interest rates will jump on any indication Trump is moving on either immigration or tariffs, and that will depress equities.
• Powell has been hyper-focused on what he observes, not what lies ahead. The Chairman may be facing a small rebellion against his data dependent approach.
  

Recently, market manias have formed on the back of easy monetary and fiscal policy. Let us hope that any revolution next year stays contained within the halls of the Federal Reserve and leaves the bubbles untouched.

Did We Get Off Easy?

It could have been worse. If the FOMC targeted their policy rates solely using the Taylor rule, Wednesday’s rate forecast could have delivered an even greater shock for investors. The Taylor rule takes the gap between current and targeted inflation, plus the actual versus potential GDP growth rate, to set an optimal Fed funds rate policy.

The equity market fell when the Fed sliced September’s 2025 forecast of four cuts down to only two, but only one cut next year aligns better with the Taylor rule. Across all members of the FOMC, September’s highest inflation forecast was 2.5% for 2025, but the revised data shows that high expanded to 3.2% for next year. That jump certainly justified moving up the year-end funds forecast by 50 basis points. But what most have ignored is that the unemployment rate estimate fell, and the GDP estimate moved higher since September, which calls for an even more restrictive policy stance through next December.

All else equal, we could be see the Fed’s funds forecast rise even higher when the March 19 SEP estimates are released. If our view plays out that inflation moves higher from tariffs or immigration, then brace for an uptick in Fed inflation forecasts.

Therefore, a strong possibility exists that the conversation can soon flip to considering rate hikes. Expect more market volatility stemming from any inflation revisions out of the Fed.

Teal is all the Rage

We had a collision of colors last week; the Fed Chair told a white lie about the Tealbook. The September 2018 Tealbook analyzed two economic scenarios based on a tariff-driven rise in import prices. Chair Powell was asked about the analysis last month, and he immediately dismissed the study, saying the economy was in a much different place six years ago. However, he changed his tune last week, saying, “I do think the September 2018 Tealbook alternative simulations are a good place to start.”

Again, this is more evidence of the tide turning at the FOMC, perhaps without Powell’s consent. The reason why Powell wanted to ignore the 2018 report is evident: the analysis showed core PCE rising from 2% to 3.5% as a result of tariff-driven inflation. We had mentioned the implications of the 2018 “Risks and Uncertainty” study a month ago. The cat is now out of the proverbial bag, and in full view of the public. Expect to start seeing the phrase “tariff-driven inflation” becoming part of the lexicon. All of this is working toward higher inflationary expectations, and the Fed will need to push back against that in 2025 with potential rate hikes.

What to Look for This Week

1. Monday, December 23 at 2:00 p.m. E.S.T. the New York Fed Multivariate Core Trend Inflation Index for November. Not widely popular among investors, but the FOMC does watch it, especially NY Fed President and influential voter John Williams. This gauge was built to determine whether inflation can persist and is broad-based, or concentrated in a few sectors, such as core services ex-housing. It has been moving up slowly similar to late 2020 before it gave an early warning about higher PCE inflation in 2021, so we are watching closely.

2. Tuesday, December 24 at 10:00 a.m. E.S.T. November New Single-Family Home Sales is released. Normally, we track Building Permits, but October New Home Sales hit 610,000, almost a two-year low. We will see if there is an election lift, or if higher long-term rates  pushing 30-year mortgage rates to a 6.82% average last month dampened sales.

3. Thursday, December 26 at 8:30 a.m. E.S.T. Initial Claims. Last week Claims were down, showing an improved labor market, but the recent trend is still up in the 4-week moving average for jobless claims. A continued move higher is still a problem for an economy struggling with a 10-year Treasury note yield that is now above 4.5%.

Note: Happy New Year to you and your family from Pave!