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As we approach the end of the year, this week holds particular significance for macro observers. The three major central banks, often referred to as the “Big 3” – the Federal Reserve, the European Central Bank (ECB), and the Bank of England (BoE) – are all scheduled to convene. The November Consumer Price Index (CPI) report in the United States also stands out as one of the final top-tier economic releases from the world’s largest economy.
But as usual, most of the market attention bears down on the Federal Reserve meeting, where this time around, Jerome Powell is expected to face questions regarding the timeline for potential insurance cuts. Simultaneously, Christine Lagarde of the ECB may aim to temper speculation about aggressive rate cuts, with some speculating on cuts beginning as early as March or April.
In the Eurozone, the notable speed at which inflation has receded has drawn the FX community’s attention, where EURO bears are prowling once again. Even Isabel Schnabel, not known for her dovish views, acknowledged as much about the falls in inflation.
The precarious state of the European economy, particularly with Germany facing significant challenges, adds another layer of caution to the current economic landscape. The region is on the edge of a potential recession, raising concerns about the overall health of the European economy. Despite Christine Lagarde’s statement in October that “The fact that we are holding doesn’t mean we will never hike again,” the prevailing sentiment suggests skepticism within the market regarding the likelihood of any imminent rate hikes from the ECB.
The Bank of England (BoE) finds itself in a challenging position, and the outcome of November’s meeting was characterized as a “confused hold.” Despite some positive developments on the inflation front, the overall outlook for the UK economy remains precarious. Policymakers are navigating a delicate balance between grappling with very high inflation and the potential for prolonged, underwhelming economic growth. In essence, the Bank of England is treading a tightrope, attempting to strike a balance that ensures stability in the face of divergent economic forces.
The upcoming November US Consumer Price Index (CPI) report is anticipated to show a 0.3% month-on-month increase in the core gauge, while the headline is expected to remain flat. On a year-on-year basis, core price growth is projected to stay at 4%, double the target. Notably, the October CPI report significantly boosted last month’s stock and bond rally.
While any disappointment (meaning a hotter-than-expected reading) in the November CPI report has the potential to reverse some of the market euphoria, particularly in the context of robust November Non-Farm Payroll (NFP) figures and an overshoot in Average Hourly Earnings (AHE), a significant upside surprise would be needed to alter the prevailing dovish narrative substantially.
As we approach year-end, this week’s developments and discussions among central banks and economic data releases will be the ultimate place-setters shaping market expectations.
The Federal Reserve
The Federal Reserve officials are currently grappling with a delicate balancing act, weighing two potential risks. On the one hand, there’s the concern that they might act too slowly to ease policy, leading to an economic downturn under the strain of higher interest rates, resulting in significant job losses for millions of people.
On the other hand, there’s the fear of easing too early, which could result in inflation settling above 3%. This level of inflation is inconsistent with the Fed’s 2% goal, which is designed to provide a level of precision and uniformity for businesses, consumers and market participants alike. This delicate balance reflects the challenge of navigating the complex economic landscape and making policy decisions that address employment and inflation concerns.
The diminished pressure on prices has alleviated concerns at the Federal Reserve that consumers and businesses might start anticipating a prolonged period of high inflation, thereby contributing to its persistence. The slower wage growth has helped ease fears of that vicious “wage-price spiral,” a scenario in which sustained inflation is fueled by a cycle of rising wages and prices. The combination of these factors has likely influenced the Fed’s stance on inflation and provided some reassurance regarding the potential for an inflationary spiral and rate cuts.
So, the most critical question facing the economy and financial market participants next year is not whether the Federal Reserve will cut interest rates but how quickly and deeply they will within two critical probable scenarios.
First, the Fed would cut simply because the economy is slowing and unemployment is rising faster than expected. If the unemployment rate starts to rise in a way consistent with past recessions, investors will start running the historical Fed playbook and price in a rapid and more profound rate-cut scenario.
A second, more tempting prospect for investors is that the Fed would cut even though the economy is doing fine because monthly inflation readings have returned closer to the low levels seen before the pandemic. Holding rates steady as inflation falls would lead inflation-adjusted, or “real,” rates to rise, which the Fed doesn’t want. So, officials could cut nominal rates to keep real rates steady.
Fed governor Christopher Waller fueled optimism about that possibility when he said recently that the central bank could theoretically begin reducing rates by the spring if inflation behaves exceptionally well.
Indeed, “insurance cuts” have gained traction—cuts made to prevent mechanical tightening. This notion, often called “cutting to stand still” within the context of the real policy rate, encapsulates the “Waller pivot.”
But hopefully, by the week’s end, investors will have some clarity on the Federal Reserve 2024 playbook.
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