“Disinflation” Is the New “Neutral”

Articles From: Interactive Brokers
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Chief Strategist

Interactive Brokers

I must admit that when it came to Chairman Powell’s press conference, I was wr…, wr…, ahem, less than accurate.  There seemed to be ample reason for him to come out in “Jackson Hole” mode, but instead passed up on multiple chances to take a hawkish stance.  The Chairman had numerous opportunities to offer a hawkish diatribe, but instead he harped on disinflation and data dependency.  Traders loved the sound of the word “disinflation.”  He used some version of the word 11 times.  A nascent selloff abated and reversed at the first mention of the term, then continued to advance with each successive mention.  The good feelings continued through yesterday’s session.

This morning’s eye-popping payrolls report gave us a possible clue about why he was more than willing to have us focus upon upcoming data.  If you’ve been assiduous in your assertions that the labor market remains solid and a key influence upon the path of future rate policy, an wildly unexpected gain of 517,000 jobs in January – nearly triple the 188,000 consensus when we include the upward revision to December – and a 3.4% unemployment rate – the lowest since 1969 – certainly offered a solid case for letting the data speak for itself.  Why try to make the case for a peak rate forecast of 5% or more when economic statistics can make the case for themselves?

The bond market is getting the message loud and clear.  Just yesterday, 2-year Treasuries were flirting with a 4% yield.  This morning they are at 4.25%.  We see 10-year yields up 13 basis points, keeping the 2-10 inversion around 62 basis points, reflecting a continued concern about a potential recession.  Fed Funds futures are back to indicating a peak rate of 5% in June and 2-3 cuts of 25bp by this time next year. 

Could the bond market be completely wrong about the potential of a Fed-induced recession later this year?  Sure.  Could stocks be completely correct about the potential for a soft landing, if not averting an economic slowdown altogether?  Sure.  My opinion is that they are both correct and incorrect at the same time.  I believe that a robust labor market will allow the Fed to raise rates higher and maintain them at peak levels longer than the markets currently expect; and by being relatively stubborn about cutting them, could bring about a relatively sharp slowdown later this year.

The initial reaction from stock index futures was predictably negative.  ES futures were down over 1% in the immediate aftermath of the report and stayed lower until a few minutes before the official open.  Then we saw a quick bounce off the lows and a steady grind higher.  As I write this at around 11AM EST, the S&P 500 Index (SPX) is flirting with the unchanged level.  Stock traders are once again proving their remarkable ability to bend almost any data to the prevailing market mood.  Stocks have been on the rise, most recently on the “disinflation” theme.  The data point that can rationalize today’s lack of concern is that monthly average hourly earnings rose by an as expected 0.3%.  Annualized, that’s still well above the Fed’s 2% target, but “no worse” is clearly good enough for a market that wants to go higher. A better than expected ISM services report, normally a minor indicator, also added to the positive tone. 

Part of my rationale for that *ahem* less than accurate assessment about Powell’s likely tone came from the fact that SPX fell after 5 of the last 6 FOMC meetings, something we noted on Wednesday.  The lone exception was in July.  I felt that the reaction to this week’s press conference was analogous in many ways to that July event.  At the time, traders seized on this description of monetary policy:

 CHAIR POWELL. So I guess I’d start by saying we’ve been saying we would move expeditiously to get to the range of neutral. And I think we’ve done that now. We’re at—we’re at 2.25 to 2.5 [percent], and that’s right in the range of what we think is neutral.

“Neutral” became the buzzword for the next few weeks.  Never mind that a wide range of Fed talking heads pushed back upon that notion almost immediately.  (And of course, never mind that 2.25%-2.5% is very much in the rear view mirror.)   It was a solid enough reed for a recovering market to cling to and use as a rationale for a rally.  The good feelings persisted until late August, when the infamous Jackson Hole address brought them to an abrupt halt.

While I see the market’s current affection with “disinflation” as analogous to its prior flirtation with “neutral”, they are not necessarily the same.  Neutral referred to monetary policy, which is in the Fed’s direct control.  Disinflation is something that the Fed can influence, but hardly manage with precision.  It seemed obvious in July that a 2.5% rate was anything but a neutral monetary policy – moreso with 20-20 hindsight, of course – but the jury is still out regarding disinflation.  It is clear that inflation appears to be slowing.  But slowing inflation is the second derivative of prices.  The rate of price rises may be slowing, but inflation itself – the first derivative of prices – is still well above the Fed’s target.  It seems that the Chairman would rather try to let the data itself deliver the sort of news that could keep rates higher for longer rather than being the bearer of bad news himself.

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