Fed in a bind as 'narrative wars' take hold

Just over four months into 2024 and inflation has upended earlier forecasts. Salman Ahmed explains why that means more volatility ahead.

Salman, what was your biggest takeaway from the latest Federal Open Market Committee (FOMC) meeting?

The big takeaway is that inflation is the most important variable in the macro space right now. Demand remains strong, especially labour demand. And we saw US Federal Reserve (Fed) Chair Jerome Powell acknowledge the stickiness of inflation to signal that the Fed is not ready to cut yet.

So we now have a very different narrative from when we started the year. The story at the start of the year was based on a soft landing, a gradual disinflation process, and the Fed starting to cut interest rates. That's categorically not where we stand in May.

What does that mean for monetary policy?

Our baseline now is that there will be no cuts at all to rates this year. The economy is still quite strong and the stickiness in inflation shows little sign of going away, especially in services, which are very demand sensitive. Rate cuts keep getting delayed, and we have not seen any meaningful progress towards the 2 per cent inflation target.

But that all said, we also understand that the bar for hiking to start again from here is pretty high.

So they can’t cut yet and hiking looks difficult too. Does that mean we’re in for a smooth ride while interest rates stay put?

We’re seeing what you might call ‘narrative wars’ taking hold. You’ve got the market trying to get in sync with the central bank, because bond market participants in particular are taking their cues from the Fed. Right now, the market is pricing in around one interest rate cut in 2024, which is a drastic change from the six that were priced in at the start of the year, and the two or three priced late last year when the initial signs of a pivot started to come through. 

And that central narrative could change further? 

The scale of that change in the market's assessment of where policy goes from here tells you that both the markets and the Fed are grasping for straws. 

Forecast errors have gone up significantly because the economy has been exceptionally difficult to predict and the narratives will keep shifting. That suggests more volatility to come.

Aside from volatility, what are the market implications of the Fed’s current position?

Because we’re not seeing the kind of progress on inflation we were expecting at the start of the year, real rates have stayed higher for longer, at levels that are restrictive in our view. 

But there are also very powerful sector effects in play as well. The economy is doing well. Consumption is still strong. Earnings likewise. So the equities picture is very nuanced. That means the earnings cycle remains important.

In the bond markets, the market narrative is very much taking cues from the signals the Fed sends. The Summary of Economic Projections still suggests sustained progress towards the 2 per cent target but we think that may be difficult to achieve in 2024 given the state of the economy.

All in all, we are expecting more volatility from here because the macro situation is becoming more complicated, and we expect more dispersion between sectors and companies.