Panic in the ranks? Reaction to yesterday’s US CPI numbers for March certainly looked like it. At an annualised rate of 3.5 per cent for the month – 0.1 per cent higher than consensus forecast – the number isn’t pretty. It puts a big damper on markets’ hopes for early and aggressive rate cuts on the part of the Federal Reserve and, as a consequence, by its friends and relations.

The February number had been 3.2 per cent and an increase on the back of higher oil prices had been forecast but not by as much as it turned out. Estimates for the monthly increase in consumer prices at both headline and core level had been 0.3 per cent though both reported in at 0.4 per cent. Thus, the core rate of inflation, which excludes food and energy, defied expectations by remaining at 3.8 per cent and not dropping to 3.7 per cent.
Most news reports will focus on the 1.09 per cent that the Dow Jones Industrial Index lost or the 0.95 per cent given up by the S&P500. Unusually, it was the Nasdaq that fared best – or least bad – closing down by 0.84 per cent. The real mood music, however, was being played in the bond markets where the yield on the two-year Treasury note, regarded by cognoscenti as the yellowest canary in the interest rate coal mine, shot up by over 20 bps to be trading at the time of writing at 4.95 per cent, a level last seen in November. In mid-January and at the height of the markets’ enthusiastic expectation for no less than six rate cuts by the end of 2024, that yield had fallen as low as 4.13 per cent. In January, the yield on the 10-year note had been marked at 3.86 per cent. That is now at 4.53 per cent.
I dread to think about how many column inches will be printed today on the subject and most of them written by people who have but the scantest of understandings of the private life of bond markets. Actually, and it pains me to write this, too many of those who trade the market don’t really understand it either. How good our ivory tower-bound central bankers might even be questioned in some circles. Either way, the numbers shocked and markets ran for cover.
The interest rate trajectory has for some time been doubtful, but nobody could fault Fed Chairman Jay Powell for not having again and again warned markets not to get ahead of themselves. Would they listen? A couple of days ago, I heard some goon on the TV suggest that the dot plot needed to be revised. Or did he say adjusted? The dot plot, for those not acquaintes with this toy, is a compilation constructed by the Fed itself which tries to forecast future monetary policy action based on what individual members of the Federal Open Market Committee, the FOMC, have said in the many public speeches they each give. It’s a sort of barometer that aims to measure the level of dovishness and hawkishness across all committee members. The dot plot, my dear boy, is the effect and not the cause.
It might be true that some of the committee members, Powell included, have spent a lot of time reassuring the rest of the world that three rate cuts between now and the end of the year are the base case. They said it when the markets were trying to convince themselves that there would be six cuts and they might well continue to say it now that the sentiment has swung towards there being none or, as former Treasury Secretary Larry Summers now suggests, rates might in fact rise before they fall.
Let’s have a look at the facts. March headline CPI is 3.5 per cent and the core is at 3.8 per cent. Fed funds are set in the target range of 5.25 per cent to 5.50 per cent, so let’s call that 5.50 per cent. The real interest rate, the inflation-adjusted return, is therefore at 2.00%. Historically, that’s a lot. In my mind, it’s also more than enough. The breakdown of yesterday’s release reveals nothing that we should not have already known which is that the resilient price pressures come from gasoline and from residential rental costs. Will higher rates make a difference to the price of fuelling the car? No. Do rents come down when the cost of financing a property goes up? You’d have to be joking.
Not long ago, and briefly moving back across the Atlantic to this sceptred isle, Maggie Pagano wrote a wonderfully lucid piece in which she perfectly rationally argued that interest rates needed to be lowered if inflation was to be tamed without killing the economy. We surely all remember the debates about whether people who died with Covid could rightly be listed as having died from it. Cause or effect? Pagano’s argument, if my memory serves me, was that lower interest rates would restore disposable income and thus support broader consumption which in turn would help the economy to recover. At the same time, the cost of money had reportedly been the main driver of price rises. Take that out and the excuse to increase prices goes out with it. That’s not wrong.
Received wisdom is that today’s monetary policy action will take anything between one and two years to have a meaningful effect on the economy. That period is at best a thumbnail and I have no memory of anybody looking at an economic metric and writing that it is what it is as an effect of an increase or decrease in rates two years ago. Most books refer to interest rate policy as being a blunt instrument. I would add that it is not only an imprecise science, it is no science at all. The psychological effect of central bank action is surely far more significant than the monetary one. In conversation with a personage who has surely forgotten more about money market matters than I will ever know, we agreed that, if anywhere, it’s in the management of money supply that the economy can be steered. And when did YOU last look at M2?
In January 2020 – so at the beginning of the pandemic – US M2 stood at around US$ 15 trillion. By April of 2022, that had shot up by nearly a quarter to US$ 21.7 trillion. Then it began to decline but the curve soon flattened out at between US$ 20.6 trillion and US$ 20.8 trillion. There is more than enough money sloshing around in the system which the resilient GDP figures adequately reflect. Hence my long-held opinion that rate cuts are not really necessary. Current real interest rates would also not necessarily point to the need to increase them either. The psychological effect of a small cut, even if only one and by as little as 25 bps, would go a long way. I read overnight an opinion that even if nothing is done in either June or July, there is still room for three cuts between September and the end of the year. Maybe things have changed but it used to be a given that the Fed would try not to fiddle around too much before general elections – and those take place in November.
So where are we? Inflation can do one of three things. It can continue to go higher, it can reverse the current trend and resume its trip lower, or it can remain where it is. I believe that with funds at 5.50 per cent, the Fed has no need to tighten unless core inflation pushes back above 4 per cent. Even at that level, it has room for a small ease if it is agreed that it is not set to go higher still. With the American commercial real estate market in the mess in which it is, and with the residential rents under upward pressure, the Fed would probably be advised to draw a line by way of a small ease. Point out that it’s not the beginning of an easing cycle but that there is, nevertheless, room for manoeuvre. Was that not what Richard Clarida, former Fed Vice-Chairman, had suggested as recently as last week?

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