Overview
A change of tune by the US Federal Reserve, Max?
Yes. What we saw in the Summary of Economic Projections, the press conference, and from Jerome Powell himself, absolutely surprised both us and markets. If we think about where things are going forward, it is a big shift. Really it comes down to them banking progress on inflation, that has been legitimate and real, sooner than we expected. There is no doubt that inflation outcomes are improving. But we were expecting them to watch those for maybe a quarter or two, to make sure they were really embedded in the system, before coming out and saying OK, this looks good, we’re going to start signalling cuts in March.
Markets reacted sharply.
Yes, a lot of things have shifted. If the Fed does follow through it makes sense that markets are moving to price in a soft landing to a greater degree. As a result, equities are up and we have seen the two-year yield fall sharply, with longer term yields down as well.
What would that soft landing consist of?
A soft landing really means that you get inflation back down to target without the need for growth and labour market damage, i.e. people getting laid off.
It definitely seems clear to us that the Fed believes that it is successfully navigating towards that outcome. And if it does indeed pivot to lower rates then the risk of a deeper balance sheet recession is taken off the table.
But you’re not convinced that’s the end of the story?
No. If the Fed goes through with this easing, and if markets move to price it in more aggressively, you'll see inflation climb back up and inflation in the longer term will be higher. That’s something we’ve been saying for a while: that inflation is going to run higher for longer, averaging around 3 per cent over the next 10 years. It is politically convenient for policymakers to allow inflation to remain higher for longer because it inflates away the gigantic debt burden the US is facing faster than it otherwise would.
And next year may not be all plain sailing?
While there will be this more gentle slowdown initially consistent with a soft landing set-up, we do believe there will still be a dip into an average cyclical recession driven by lagged effects of policy. That’s because we are already seeing leading indicators, such as credit lending, weaken and we expect that to properly come under stress in the second half of next year.
So our outlook is for soft landing-like outcomes now, reinforced by the Fed, but for that to be followed by recession later in the year. That said, if the Fed's pivot is indeed backed by action in the form of heavy front-loaded cuts in rates as we progress through 2024, the longevity of the current soft landing phase may also extend.
That’s still a big contrast with Europe.
Yes, the European Central Bank (ECB) meeting was very different, arguably it was a surprise to the hawkish side rather than to the dovish side. Really our outlook for the ECB is about differing views on how macro outcomes will evolve.
So, the ECB's staff forecasts are for growth of just under 1 per cent next year. If that's your macro base case, then it makes sense to remain on the hawkish side.
However, we don't believe they should have hiked when they did last time and we believe they've already gone far enough now. We are convinced that recession in Europe will happen next year and increasingly the market pricing says the same thing. If that’s true, then this continuation of tighter for longer absolutely is a mistake and will just make the recession deeper.
