Bogeyman Powell
Last year, after the December meeting of the US Federal Reserve (Fed), its Chair Jerome Powell gave a surprisingly accommodative speech. This was the moment of the famed pivot in monetary policy, as the central bank closed the chapter on rate hikes and started to think about cuts in the future. This speech was a Christmas gift to the markets for risky assets, which closed 2023 on a high for the year.
In contrast, there were no pleasant surprises in Father Powell’s sack this year. Whilst Fed members again reduced rates by 0.25%, bringing the total cut over the last three meetings to 1.0%, the tone was less indulgent. The governors now only expect two further cuts in 2025, whilst back at the September meeting they were anticipating double this. On the inflation front, the Fed envisages much higher underlying inflation at the end of 2025, of 2.5% versus a previous estimate of 2.2%. As for GDP growth, whilst it has been revised upwards substantially for the current year, there has been only a modest revision upwards to 2.1% from 2.0% for 2025. This drastic reduction in the speed of rate cuts combined with the prospect of clearly stronger inflation and more or less unchanged growth undoubtedly represents a potent mix sufficient to explain the extremely negative reaction of equity markets. The S&P 500, for example, chalked up its worst performance after a Fed meeting since March 2000.
The severity of this reaction may appear surprising: in fact, by reducing its forecast number of rate cuts from four to two, the Fed has simply aligned itself with recent market expectations. Undoubtedly markets were expecting the central bank to remain a little more accommodative. As to the issue of inflation, the significant revision to expectations for 2025 does raise a question. But Jerome Powell acknowledged that, on the one hand, some Fed members had built in a hypothetical impact from Donald Trump’s trade tariffs policy, and on the other, that in the shorter term, recent figures were reassuring.
This brutal market movement highlights two factors. Firstly, the very high valuation level of US equity markets – in absolute terms and relative to other equity markets and to their own track record – combined with extremely high optimism among investors. This reflects expectations of a perfect economic scenario and puts US equities in a situation where any hint of bad news can have a high cost. This situation is likely to persist until valuations return to more reasonable levels.
Secondly, the extreme sensitivity of markets – and some central bankers – to the inflation issue. Of course this is understandable, when we are leaving a period of high inflation and entering the last – and the longest – mile on the road to disinflation, and with the potential for Trump’s policies to completely reshuffle the deck. However, this creates another unfavourable asymmetry. At this stage, inflation is still falling, albeit it at a very modest rate, and this could become more obvious in a few months when the sharp hike in prices at the beginning of 2024 drops out from the calculation basis. In parallel, employment has been largely forgotten, but continues to gradually deteriorate, with weak private-sector job creation and a rising unemployment rate, less and less as a result of the rise in the active population, but increasingly due to clear job losses.
At the end of 2023, the Fed’s tone was highly accommodative and rates fell sharply. In subsequent months, both the narrative and the trend regarding interest rates reversed. Will the same thing happen this year, for example, with positive surprises on inflation accompanied by negative surprises on employment? In any case, this scenario is worthy of consideration, given the current high level of consensus on the inflationary risk.