US core PCE inflation softens as expected by Fed’s Powell

Wall Street Futures and gold soared Thursday on hopes & hypes of an early Fed pivot/put. The market was expecting -100 bps Fed rate cuts in 2024 and 2025 each (from June 24) and QT tapering from June’24 to close the same by Dec’24. But going by the overall Fed/Powell statements, Q&A comments, trend of core inflation, and also the Nov’24 US Presidential Election, the Fed may go for -75 bps rate cuts in 2024 starting from September after closing the QT by Aug’24. Previously, the market was anticipating Fed rate cuts from June’24. The CME Fed swaps now price in only -75 basis rate cuts in 2024 against earlier -150 bps a few months ago.

On Thursday, Wall Street Futures closed almost flat amid QTR end portfolio rebalancing and hopes & hypes of an early Fed cut. But for Q1CY23, broader SPX-500 jumped +10.2%, the best Q1 gain since 2019, while export/China savvy blue chip DJ-30 gained +5.6% and tech-heavy NQ-100 surged +8.6% on AI and Fed pivot optimism. The market is now expecting deeper Fed rate cuts in 2025-26 as Trump is set to return to the White House. Fed may also end QT early by Aug’24 at a B/S size of around $7.00T. Gold is getting a boost from never-ending US deficits, debt and also dollar devaluation, and elevated inflation; average headline CPI is still higher by over +20 from pre-COVID levels. Also, lingering geopolitical tensions over the Gaza and Ukraine war are supporting gold along with lower bond yields.

Gold is getting a boost as the Fed may end QT by Aug’24 before going for rate cuts from Sep’24. On late Thursday, Gold suddenly jumped from around 2220 to almost 2236 in a holiday-thinned market for apparently no specific trigger. Gold jumped +9.26% in March and 13.44% in the last year. The US 10Y bond also rec0vered around +8% since the Sep’23 low of around 105.

Ahead of the Nov’23 U.S. Presidential election, White House/Biden/Fed/Powell is more concerned about elevated inflation rather than the labor market; prices of essential goods & services are still significantly higher than pre-COVID levels, by around +20% which is creating some incumbency wave (dissatisfaction) among general voters against Biden admin (Democrats).

Thus Fed is now giving more priority to price stability than employment (which is still below 4%) and not ready to cut rates early as it may again cause higher inflation just ahead of the election. Fed may hike only from Sep24 (H2CY24), which will ensure no inflation spike just ahead of the Nov’24 election (as any rate action usually takes 6-12 months to transmit in the real economy), while boosting up both Wall and Real/Main Street. Fed may announce a plan for QT tapering/direct closing in the May meeting and close the same by August’24 before going for rate cuts from Sep’24. Fed, the world’s most important central bank may not continue QT and rate cuts at the same time because QT (even at a slower pace) and rate cuts are contradictory; QT is a tool for financial tightening, while rate cuts are just the opposite.

On the Good Friday holiday, some focus of the market was on U.S. Core PCE inflation for February. The BEA flash data showed U.S. annual (y/y) core PCE inflation (at 2017 constant prices) for January further eased to +2.8% from +2.9% sequentially, in line with the market expectations of +2.8% and lowest since Mar’21 (three years).

On a sequential (m/m) basis (seasonally adjusted at 2017 constant prices) the U.S. core PCE inflation also eased to +0.3% in February from upwardly revised +0.5% in January, in line with market expectations of +0.3%; January’s +0.5% sequential rate was highest in last one year (since Feb’23).

In February, the U.S. core PCE service inflation ex Housing/Shelter, the current focus of the Fed remained stalled around +3.3%, while easing to +0.2% sequentially from +0.7% in Jan’24. Also, PCE service inflation eased to +3.8% in February from +3.9% in January.

Fed is now also talking about Dallas Fed Trimmed Mean Inflation, which was +3.1% in Feb’24 against +3.2% in Jan’24.

Overall, after the latest revisions, the average core PCE inflation for 2023 is now around +4.1%, while the same for core CPI inflation is +4.8%, and an average of core PCE+ CPI is around +4.5%. The Fed usually goes by a 6M rolling average of core PCE inflation for any important policy move. As per the new series (2017 constant prices), the 6M rolling average core PCE inflation is now around +3.1%, while the 6M rolling average of U.S. core CPI inflation is now around +4.0%; i.e. 6M rolling average of US core inflation (CPI+PCE) was around +3.6%, still far above Fed’s +2.0% targets.

Fed needs an average sequential core PCE inflation rate of around +0.15% on a sustainable basis for its +2.0% core PCE inflation targets. But it was still hovering around +0.25% for the last 6 months, while jumped +0.45% even in Jan’24. That’s why Powell repeatedly pointed out Fed is not confident enough still now for the disinflation process, but there is a declining trend and the Fed is confident that it will gain confidence enough soon about core PCE inflation falling on the way to +2.0% on a sustainable basis.

Moreover, several US Senators/Congress members, both Democrats and Republicans are now grilling extensively (ahead of the Nov’24 election) about still elevated inflation compared to pre-COVID levels (by at least +20%) and insisting that Fed/Powell should focus on core CPI inflation rather than core PCE inflation, which is around 1% lower most of the times due to composition/weightage issue.

Powell also publicly acknowledged to a Senator in the last hearing/testimony that US Congress officially mandated the Fed to maintain price stability mandate as +2% headline inflation (CPI), not PCE, which is always the lowest among various inflation gauzes. Powell pointed out that the Fed is now actually targeting core CPI inflation due to lower volatility (ex-food and fuel), which is still higher than headline CPI. Overall, core PCE inflation is now a lagging indicator, and does not impact the market meaningfully as the market already has an idea about the level after core CPI inflation data was released almost 2-weeks ago.

Oil is now hovering around $83, meaningfully higher than the $68 area at the start of the year (2024). Looking ahead Russia and Saudi Arabia may orchestrate some rally to $90-105 in oil to ‘teach a lesson’ Biden ahead of the Nov’24 Presidential election; Putin may prefer Trump as the next US President than 2nd term of Biden. If oil indeed soars to $90-105 areas in the coming days due to lingering geopolitical tensions (Gaza, Red Sea, and Ukraine war) and OPEC+ production cut agreement extension, the Fed may face some real difficulties in cutting rates even in H2CY24.

On Good Friday White House also reacted after the release of Feb’24 core PCE inflation data:

·         President Biden: latest core inflation numbers real progress

·         WH Economic Advisor Brainard: There is more work to do to lower costs for families

·         Biden administration to cap rent increases for some affordable housing units

·         Under new regulations to be announced Monday, The Biden administration will cap yearly rent increases at 10%

On Good Friday, Fred Chair Powell said in a conclave organized by SF Fed led by President Daly:

·         My first thought on PCE was in line with expectations, good to see it in line with expectations

·         The February reading is more along the lines of what we want to see

·         We didn't overreact to last year's good data, you won't hear us overreacting to these two higher months this year

·         Reducing rates too soon would be very disruptive

·         Waiting too long could mean unneeded damage to the economy and the labour market

·         We are ready for the economy to perform in unexpected ways

·         Monetary policy is well-placed to react to a range of different data paths

·         Today's PCE report is 'pretty much in line with our expectations'

·         Getting it right is the most important thing by orders of magnitude

·         We want to be more confident before we cut rates

·         We've been surprised by data; we have to be unusually humble and ready for different outcomes

·         We've been saying we expect inflation to move to 2% on the sometimes bumpy path

·         We're going to have to let the data tell us if it's a bump, we don't know

·         If our base case doesn't happen, we would hold rates where they are for longer

·         We don't know where rates are going to go back to when this whole thing is over

·         The economy is not suffering from this level of rates

·         You have seen significant progress in inflation

·         The work on inflation is not done, but risks on the Fed’s two goals are in better balance

·         The possibility of a recession is not elevated now

·         Although there is always a theoretical probability of a recession down the year, looking at the current set of data, it’s not the base case anymore; the economy is really strong

·         We have a chance to ease inflation without hurting the economy

·         There's no reason to think the economy is in or on the edge of recession

·         Slowing the runoff of the balance sheet (QT) is not the main story of monetary policy

·         At a certain point, we will slow the runoff pace for the balance sheet (QT tapering)

·         By slowing the pace, we're trying to get further on shrinking the balance sheet without being disruptive like in late 2019, when the Fed had to start small QE again (even before COVID)

·         Slowing balance sheet runoff is not in any way related to the view of the economy

·         Fed will start QT tapering at a certain point of time/balance sheet size taking lessons from the 2019 QT fiasco

·         Fed may like to keep the B/S size at or even below the level that does not disrupt the funding/money market (from the 2019 QT tapering tantrum lesson)

·         A unanimous decision doesn't mean there weren't different views

·         Rate decisions aren't fully baked before the policy meeting

·         We've worked with banks to address issues with CRE

·         Some banks, mostly small banks, have CRE concentrations. We're working with them to make sure they have enough capital, I think that will be ok

·         CRE will be a problem for some years

·         The fact that the US is growing solidly and, the labor market is strong, gives us the chance to be a little more confident about inflation until cutting rates

·         Fed will be politically independent irrespective of who is in the President at White House; i.e. Fed will ensure its credibility even under the next probable President Trump

Fed’s focus is now on maintaining an appropriate B/S to ensure dual mandate and financial stability:

On Friday, Fed Chair Powell reiterated Fed is in no hurry to cut rates, while the core PCE inflation data for February was in expected lines, which the Fed wants to see. However, the Fed wants to see more progress on disinflation as the latest readings aren’t as good as what the Fed saw last year in H2. Thus the Fed can wait to gain more confidence before cutting rates. Moreover, Powell even said the Fed's base case is for inflation to come down but if that doesn't happen the Fed would hold rates where they are for longer than the market is expecting.

On Friday, Powell also gave more light on the Fed’s thinking about the QT tapering plan as B/S shrinkage to an ideal size without disrupting the US money/funding market is a challenge for the Fed; previously Fed failed to do the QT fully and has to abandon abruptly after late 2019 QT tantrum, which even forced Fed to launch a mini QE even before COVID. Powell indicated an equivalent lower or even lower B/S size than the Fed planned in 2019, but failed!

Fed needs to do the QT and shrink the B/S not only to prepare itself for the next QE (financial crisis) but also to bring itself out of a huge MTM loss (currently around $160B) as a result of lower bond prices (HTM bond portfolio) and relatively higher interest being paid on bank reserve (under reverse repo). Big banks have gained hugely from the Fed’s loss when the Fed raised rates and bond yield goes higher.

Fed’s B/S size is now around $7.55T (as of the week ended 27th March 24), reduced from around $8.96T life time high scaled in Apr’22. Fed is doing QT from June’22 with a pace of $0.048T/M till Aug’23 and presently at a higher pace of 0.095T/M from Sep’23 (after ending the rate hike cycle in July’23). Looking ahead, the Fed may maintain its B/S size around $6.50T; which would be around 20-22% of the projected CY24 nominal US GDP of around $30.00T. Fed had also indicated previously (before COVID) that B/S size is around 20-22% of nominal GDP. 

In Sep’2019, QT tapering (started in 2017) resulted in B/S size falling to around $3.77T from around $4.47T, which caused severe disruption in the US money/funding market, forcing the Fed to go for small QE even before COVID. Fed may be now targeting to keep ‘ample’ bank reserve around $3.00-2.50T (@10-8% of projected CY24 nominal GDP around $30T) in its B/S against 2019 QT target $1.50T to avoid any disruption in the funding market and to ensure financial stability. In Sep’19, bank reserve fell to around $1.4T, which was around 7% of nominal GDP and triggered the REPO market crisis.

Fed is now using ON RR/RRP (Overnight Reverse Repo Repurchase) for funding market stability, especially for smaller/regional US banks (around 10% of the US banking system), there is no visible effect of QT unlike during late 2019. Fed’s bank reserve now stands around $4.0T and ON/RRP around $0.70T.

The Fed intends to taper/slow and then end QT when bank reserves are ‘somewhat’ above the level judged to be consistent with ‘ample’ reserve balances. Here, the challenge for the Fed is that this ‘ample’ minimum reserves floor is unknown. The money market stress in September 2019 revealed the threshold was much higher than $1.5T previously estimated. There are some concerns now bank reserves are close to the threshold, with overnight interest (interbank) rates trading in the lower half of the Fed’s target range.

The sharp fall in the RRP from $2.6T in May’23 to $0.980T in Jan’24 has boosted reserves. The RRP drains reserves as counterparties – typically money market funds and NBFCs – lend funds directly back to the Fed. Nevertheless, recent Fed commentary has alluded to a reserves floor of 10%-12% of nominal GDP, or $3.00T-3.60T. This is higher than estimates from around a year ago. Fed may keep $3.60T bank reserve, somewhat above ample levels of $3.0T bank reserve.

During QT times, the Fed is reducing its TSY +MBS holdings passively by not reinvesting original proceeds from maturing bonds, letting them mature and out of B/S. This is also causing corresponding bank reserves to decline. Now as the Fed is no longer buying US debts (TSYs + MBS) from the secondary market (unlike QE), US banks have to buy those US debts (mainly TSYs) but there is a risk of scarce liquidity as bank reserve also declined.

In late 2019, QT failed as big banks led by JPM refused to lend to other banks, which created the panic and then the Fed had to step in as the ‘backstop’, which made money market participants confident enough to lend to each other as Fed will bail out any defaulted entity as the last resort. Although in reality, no bank comes to the Fed for the fund, the so-called Fed ‘put’ was able to pacify the US funding/money market, the biggest in the world.

Now Fed’s QT rate is $95B/M; i.e. $0.095T/M; if Fed intends to keep its B/S size around $6.55T (@22% on estimated CY24 nominal GDP $30T) from the existing $7.55T, it needs around 11-12 more months at the same rate of $0.095T/M; i.e. by Mar’25, Fed may be able to reduce its B/S size to around $6.55T and stop the QT (without going for any tapering ?).

But Fed’s Chair Powell is now indicating an imminent QT tapering, most probably from May’24. In that scenario, the Fed may taper the QT pace to around 0.048T~0.05T/M for 20 months till Dec’25, at almost 50% of the present pace of 0.095T/M to ensure smooth QT and the end of B/S shrinkage ensuring financial stability, especially for repo market. Alternately, the Fed may also run the QT tapering at around $75B/M ($0.075T/M) pace for 10-12 months from May’24 to close the QT by Jan-May’25 at B/S sizer around $6.55T and reserve balance around $3.60T (around 12% of US nominal GDP), ON/RRP around $0.40T, cash/currency notes around $1.00T and other securities.

After the 2019 money/funding market crisis/disruptions caused by QT, the Fed introduced the ON RP/RRP lending facility (Overnight Repo and Reverse Repo Repurchase Agreement) to ensure financial stability even during QT periods, which generally causes less intention among big banks/MMFs (money market funds) to lend each other. Thus, this time QT was not disruptive like we saw in late 2019 causing some slide in Wall Street and making Trump furious against Fed/Powell.

Overall, QT is a challenge for Fed as we have seen in late 2019. The U.S. has to issue never-ending debts (TSYs) and the Fed has to absorb from the secondary market through QE. Now during the QT phase, although the Fed is not actively selling TSYs, just letting them mature by not reinvesting original proceeds, this is sufficient for higher bond yields as bond prices fall due to lower/no demand from the Fed. Moreover, during QT, US Banks/NBFCs (DIIs) generally buy more TSYs and demand higher coupon rates (bond yield). This also causes lower bank reserve, creating REPO/funding market disruption a possible QT tantrum and a new vicious cycle of QE (whatever may be the excuse).

The never-ending US debt, deficit, devaluation (currency), and inflation are boosting Gold. Looking ahead, the Fed may keep B/S size around $6.55T, around pre-COVID levels to ensure financial/Wall Street stability along with Main Street stability (price stability and employment stability).

Conclusions:

The Fed may go for -75 bps rate cuts in September, November, and December’24. By 18th September (Fed MPC date), the Fed will have complete data for core inflation and also unemployment/real GDP data for H1CY24 and also Aug/July’24 to have the required ‘higher confidence’ to go for rate cuts. Fed may bring down the repo rate to +4.75% by Dec’24 from present +5.50%.

The 6M rolling average of US core inflation (PCE+CPI) is now around +3.6%. Fed may cut 75 bps in H2CY24 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by H1CY24.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C-D)*(E-B)

=1.50+2.00+ (2.60-2.00)*(4.50.00-2.00) =1.00+2+ (0.60*2.50) = 3.00+1.50=4.50% (By Dec’24)

Here:

A=desired real interest rate=1.50; B= inflation target =2.00; C= Actual real GDP growth rate for CY23=2.6; D= Real GDP growth rate target/potential=2.00; E= average core CPI+PCE inflation for CY23=4.50

Fed may announce a plan for QT tapering/closing in the May meeting and should have closed the same before going for rate cuts in H2CY24. Fed, the world’s most important central bank may not continue QT (even at a reduced pace) and go for rate cuts at the same time as QT, and rate cuts are contradictory, although Fed/Powell kept the option open, at least theoretically. Thus assuming an absurd/bizarre phenomenon, the Fed may go for -75 bps rate cuts in H2CY24, most probably from Sep’24 after deciding about the possible B/S size to ensure money market stability

Looking ahead, the Fed may keep B/S size around $6.55T, around pre-COVID levels to ensure financial/Wall Street stability along with Main Street stability (price stability and employment stability). Fed’s B/S size is presently around $7.50T (Mar’24 end). Depending upon the actual rate/reaction in the repo/funding market, the Fed may taper the QT from the present $0.095T/M to 0.050-0.075T/M for 20-12 months from May’24;i.e. Fed may end the QT by May’25-Dec’25 at B/S size around $6.55T. This is lower than the earlier market estimate of $7.00T and thus should be seen as more hawkish. Also, rate cuts along with QT (even with slower pace/tapering) should be less hawkish.

Ahead of the Nov’23 U.S. Presidential election, White House/Biden/Fed/Powell is more concerned about elevated inflation rather than the labor market; prices of essential goods & services are still significantly higher (around +20%) than pre-COVID levels, which is creating some incumbency wave (dissatisfaction) among general voters against Biden admin (Democrats).

Thus Fed is now giving more priority to price stability than employment (which is still hovering below the 4% red line) and is not ready to cut rates early as it may again cause higher inflation just ahead of the November election. Fed may hike only from Septenber’24, which will ensure no inflation spike just ahead of the Nov’24 election (as any rate action usually takes 6-12 months to transmit in the real economy), while boosting up both Wall Street and also Main Street (investors/traders/voters). Fed hiked rate last on 26th July’23 and may continue to be on hold till at least July’24; i.e. around 12 months for full transmission of its +5.25% cumulative rate hikes effect into the real economy.

Overall, the Fed’s mandate is to ensure price stability (2% core inflation), and maximum employment (below 4% unemployment rate) along with financial/Wall Street stability as well as lower borrowing costs for the government. As the US is now paying almost 15% of its tax revenue as interest on debt, the Fed will now not allow the 10Y US bond yield above 4.50-5.00% at any cost.

Bottom line:

Fed may continue QT (even at a slower pace) and go for a rate cut cycle at the same time despite these two policy actions being contradictory. Thus the Fed may go for rate cuts of -75 bps cumulatively in September, November, and December’24 for +4.75% repo rates from the present +5.50%.

Technical trading levels: DJ-30, NQ-100 Future, and Gold

Whatever may be the narrative, technically Dow Future (40145), now has to sustain over 40700 levels for any further rally to 42600  levels in the coming days; otherwise, sustaining below 40650-40450/40300 may again fall to 39250/38700-38200/37950 levels in the coming days.

Similarly, NQ-100 Future (18465) now has to sustain over 18850 levels for any rebound towards 19000/19200-19450/19775 and 20000/20200 in the coming days; otherwise, sustaining below 18800-18700, NQ-100 may gain or fall to around 18000/17500-17200/16875 in the coming days.

Also, technically Gold (XAU/USD: 2232) now has to sustain over 2250 for any further rally to 2275/2300; otherwise sustaining below 2245/2240, may again fall to 2220/2210 and 2200/2195-2190/2180 and 2175/2145*, and further to 2120/2110-2100/2080-2060/2039 and 2020/2010-2000-1995/1985-1975 and even 1940 may be on the card.