Sharp disparity between the Fed and markets

Bottom Line

After a disastrous home loss to the San Francisco 49ers in a November 2001 regular-season game, Indianapolis Colts head coach Jim Mora offered reporters a brutal self-assessment. His Hall of Fame quarterback Peyton Manning fumbled once and threw four interceptions, one returned for a touchdown. When asked about the Colts’ playoff chances, an incredulous Mora famously responded: “Playoffs?! Don’t talk about playoffs. You kidding me? Playoffs? I just hope we can win a game!”

Federated Hermes’ macroeconomic policy committee held its first formal meeting of the year yesterday, and the discussion centered on the indefatigable labor market, the surge in business and consumer confidence, the robust retail sales ahead of Christmas and the surprising uptick in CPI inflation.

In its most recent Summary of Economic Projections (SEP) published in mid-December, the Federal Reserve indicated it might orchestrate three quarter-point interest rate cuts in 2024. Yet investors are pricing in around six. To be sure, the consensus view anticipates slower economic growth, even the potential for a mild recession, over the next year and a rapid decline in inflation. But 150 basis-points worth of cuts seems out of step. In contrast, we forecast a soft landing, with only moderate declines in growth and inflation. We are siding with the Fed, expecting the three quarter-point cuts in the second half of the year.

With apologies to Coach Mora, our response to the chasm between our forecast and the consensus is: “Six cuts?! Don’t talk about six cuts! Are you kidding me!? Six rate cuts? We just hope to get past January’s nonfarm payroll report!”

Labor market remains robust Yesterday, initial weekly jobless claims hit a new 16-month low (September 2022) for January 2024’s survey week at 187,000. The 4-week moving average hit a 1-year low of 203,250 and continuing claims hit a 3-month low of 1.806 million for the week ended Jan. 6. Moreover, the Labor Dept. in January (and July) typically implements sizable positive seasonal adjustments. So, a potentially hot January payroll number (to be flashed on Feb. 2) should keep the Fed anchored to the sidelines at the March 20 policy-setting meeting. 

Grinch thwarted Nominal retail sales for December, which rose a better-then-expected 0.6% month-over-month (m/m), were the strongest in three months, and control sales, which leapt by 0.8% m/m, were the best in five months (well above the expected consensus gain of 0.2%). That makes consumers look more like Santa than the Grinch. Importantly, control results strip out food, autos, gas and building materials, and feed directly into the Commerce Dept.’s quarterly GDP calculations. That should give the Fed pause before it starts cutting rates.

Business and consumer confidence rising:

• University of Michigan Consumer Sentiment Index surged from 61.3 in November 2023 to 78.8 in January 2024
• Consumer Confidence Index leapt from 99.1 in October 2023 to 110.7 in December
• NAHB Housing Market Index builder confidence soared from 34 in November 2023 to 44 in January 2024
• NFIB Small Business Optimism Index increased from 90.6 in November 2023 to 91.9 in December

Sticky inflation Nominal CPI peaked at 9.1% y/y in June 2022 and fell sharply to 3.1% in November 2023. But in December, it surprisingly rose to 3.4% (consensus at 3.2%). Core CPI, which peaked at 6.6% y/y in September 2022, declined sharply to 4.0% in November 2023. But it slipped to only 3.9% in December (consensus at 3.8%).

Core PCE (the Fed’s preferred measure of inflation) peaked at 5.6% in February 2022 and has declined to 3.2% in November 2023. The Fed’s target remains 2%, a level the central bank hopes to achieve by year-end 2026, according to its most recent SEP. But given the significant decline in the pace of inflation over the past two years, are policymakers too conservative in keeping their 2% core PCE target three years from now? Or are they communicating that the so-called “last mile” back to target will be like hand-to-hand combat—requiring patience, vigilance and data dependency before the Fed begins to cut rates?

We’re still bullish on stocks But maybe the bond market has it right for now. Benchmark 10-year Treasury yields have backed up from 3.78% on December 27 to an intraday 4.20% today. Perhaps the bond market is beginning to realize that the Fed’s pace of rate cuts may be closer to what they say they’re going to do, rather than what the market is pricing in. 

The S&P 500, on the other hand, has rallied 18% over the past three months, from an oversold 4,100 on October 27 to an overbought new cycle high of 4,840 today. We still expect this rally to run to our full-year target of 5,200, as stocks tend to rip on Fed pauses. But we also expect increased volatility into the election. This rally should continue to broaden out, with domestic value, small cap growth and international stocks playing catch-up, while the growth and technology stocks trim some of last year’s froth.

Adjusting our estimates for GDP growth and inflation The fixed-income, liquidity and equity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met yesterday to review the economy’s strong showing in recent days and the likely impact it will have on the Fed’s monetary policy plans:

• The Commerce Dept. will flash fourth quarter 2023 GDP on January 25. Spending on services remains relatively strong (think “revenge travel”), and holiday-related spending on goods was stronger than expected. So we increased our estimate from 1.5% to 1.9%, versus 4.9% in the third quarter. The Blue-Chip consensus raised its estimate from 0.9% to 1.5% (within a range of 0.8% to 2.4%). The Atlanta Fed’s GDPNow goosed its estimate from 2.1% to 2.4%, and the Bloomberg consensus raised its estimate from 1.5% to 1.8%.
• We left our full-year 2023 GDP growth estimate unchanged at 2.5%. The Blue-Chip consensus ticked up its estimate from 2.4% to 2.5% (within a tight range of 2.4% to 2.5%).
• Core CPI inflation finished 2023 at 3.9% y/y, down from a 40-year high of 6.6% in September 2022. 
• We reduced our year-end core PCE 2023 forecast from 3.3% to 3.1%. That compares with actual core PCE inflation of 3.2% in November 2023, down from a 39-year high of 5.6% in February 2022.
• We’re expecting a post-holiday spending hangover. But due to the higher base, we increased our estimate for first quarter 2024 growth from 0.9% to 1.3%. The Blue-Chip consensus more than doubled its estimate from 0.4% to 1.0% (within a range of 0.0% to 2.0%).
• We tweaked our estimate for second quarter 2024 GDP growth up from 0.9% to 1.1%. The Blue-Chip consensus raised its estimate from 0.4% to 0.7% (within a range of -0.8% to 1.8%).
• We expect the Fed to begin to cut interest rates by the third quarter, so we increased our estimate for third quarter 2024 growth from 1.1% to 1.4%. The Blue-Chip consensus left its estimate unchanged at 0.9% (within a range of -0.7% to 2.1%).
• We ticked up our estimate for fourth quarter 2024 growth from 1.6% to 1.7%. The Blue-Chip consensus left its estimate unchanged at 1.5% (within a range of 0.3% to 2.4%).
• As a result of these quarterly increases, we also raised our full-year 2024 GDP growth estimate from 1.7% to 1.9%. The Blue-Chip consensus lifted its estimate from 1.2% to 1.6% (within a range of 1.0% to 2.2%).
• We increased our year-end core CPI 2024 forecast for from 2.8% to 2.9%, while the Blue Chip lowered its estimate from 2.7% to 2.6% (within a range of 2.3% to 2.9%). We left our estimate for core PCE inflation unchanged at 2.5%, while the Blue Chip lowered its estimate from 2.4% to 2.2% (within a range of 1.9% to 2.7%).

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