Issue 102: FOMC Preview

This Week’s Highlights

• FOMC set to ease, but how big a cut?
  While the Fed has strongly messaged some kind of rate cut is coming this week, traders are pretty much evenly split as to whether it will be for 25 or 50 bps. After last week’s core inflation came in a little hotter than expected, we lean somewhat to the quarter-point camp.
• ECB takes another 25 bps off rates
  With euro area inflation coming down comfortably toward the ECB’s 2% target, policymakers there saw fit to follow up June’s reduction in its benchmark deposit rate with another cut last week, though the bank gave little guidance as to when the next move down may come.
• China domestic demand still weak
  Investors will hope policymakers heed signals from data on China’s economy released last week—from consumer and producer prices to growth in imports and exports—showing past stimulus has only served to boost manufacturing, as domestic demand falters.

The CIO’s Take:

• This week’s main event is clearly a Thursday reveal of the Fed’s September decision: no doubt a cut of some kind. We still lean toward a 25-bps first move, but if the FOMC does decide to go big, expect Powell to message it more hawkishly. The market will likely cheer either way, though we note prices already reflect quite a lot of good news.
• The US is actually a little late to the party, with policymakers from the BoE to the ECB contemplating additional cuts. While easing is obviously the trend—6 of the world’s top 10 central banks have already cut in 2024—we suspect investors may feel a little too dovish, with sticky inflation likely to moderate the pace of easing by many banks.
• ​​​​​Last week was full of data on China’s sputtering economy, and even super-low expectations couldn’t prevent the numbers from disappointing. While we see Chinese shares as a deep value here (and worth an active allocation, in our view, given how much upside we see), we view timing the turnaround as far too hard at this point.

FOMC Preview

Headline CPI softens
Last Wednesday brought the last big piece of data before this week’s potentially pivotal FOMC: a report on US inflation in August from the Bureau of Labor Statistics. The headline number came in at 2.5% year-over-year, a hefty drop from the 2.9% rate seen in July, the fifth consecutive decline, and a touch lower than the 2.6% analysts had expected. The corresponding monthly increase of 0.2% was right on the consensus forecast. That CPI report was just what the doctor ordered for investors expecting the Fed to reduce rates this week.

Core CPI a little sticky
But was it enough for a 50-bps cut? That’s where things get a little more complicated. It turns out that core inflation—the version of CPI stripping out volatile food and energy, on which the Fed places more focus—increased by 0.3% in August, a tick higher than economists were forecasting, keeping year-over-year core CPI steady at 3.2%. We have long worried about sticky inflation complicating the Fed’s final descent, as the central bank tries bringing the US economy in for a soft landing. Persistent pressure on core prices underscore just that risk.

Size of first cut a toss-up
You can actually see traders’ disappointment with core inflation looking at how futures reacted on Wednesday. In the chart below, we show the market-implied size of the September cut, along with the implied number of rate cuts by year-end, both of which dipped on Wednesday. On Thursday and Friday of last week, however, doves rallied behind speculation Powell would convince his colleagues on the FOMC to front-load easing with a supersized cut at this week’s meeting, pushing the odds of a half-point cut in September to 50/50.

Debate among Fed officials
The Fed has contributed to uncertainty, maintaining its poker face going into its blackout period a little over a week ago. Fed Governor Chris Waller, speaking just before communications ceased, emphasized his support for pretty much whatever “the data suggests”, whether that means “cut at consecutive meetings”, “larger cuts”, or “front-loading rate cuts”. On the other hand, prominent Fed figures like San Francisco Fed president Mary Daly and Fed Governor Michelle Bowman have defended more hawkish “gradualism” and “cautious” tactics in comments over the last month.

We see a quarter-point cut
Indeed, the sudden clamoring for a 50-bps cut really seems to rest on stories put out last Thursday by the Wall Street Journal and Financial Times, each describing the Fed’s decision as a “close call”, in what some observers felt might be leaked messaging by the Fed to prepare markets for a half-point reduction in its benchmark rate. Setting aside this bit of last-minute intrigue, we simply haven’t sensed urgency from the Fed, and still see the data as presenting more or less balanced risks. As such, our bet remains on a 25-bps cut when the FOMC concludes on Thursday.

ECB Cuts Again

Euro area inflation falling
Last Thursday, the European Central Bank (ECB) set an example for the Fed, reducing its benchmark deposit rate by 25 bps to 3.5%. That was no surprise, as the ECB has been strongly messaging a desire to further ease conditions (see below), with estimates of inflation coming down and confidence increasing that the bank is on track to achieve its 2% target. Forecasts for euro area inflation released with the decision held steady, with CPI closing out 2024, 2025, and 2026 at 2.5%, 2.2%, and 1.9%, respectively—a progression the ECB deemed deserving of a second cut.

No guidance from ECB
The big question mark was whether the ECB might offer an outlook for more cuts this year. As we expected, the bank declined to drop big hints, instead leaning into a “data-dependent” orientation, reiterating its intention to keep policy rates restrictive enough to ensure consistent downward pressure on inflation. Traders bid down the prospects of another cut from the ECB in October, but still price in one or two more quarter-point cuts this year. We think that’s reasonable, given trends in growth and inflation, both softening at a comfortable pace.

Expect BoE to hold
While the FOMC will clearly get more attention on Thursday, the Bank of England (BoE) also has a decision to make, though it’s widely expected policymakers will keep rates on hold, with futures putting only around a 20% chance on another cut to follow the BoE’s 25-bps reduction of its benchmark Bank Rate in August. We agree with markets here, and see a November cut as much more likely, though wouldn’t be shocked if the bank announces a mild acceleration in its quantitative tightening program, helping facilitate a push to get some bonds off its bloated balance sheet.​​​

China Deflation

Traders eyeing China inflation
Moving from questions of rates and inflation in developed markets, we thought we would take a look at prices in China, in search of clarity on the direction of the world’s second-largest economy. Whereas rising prices have been a big problem for Western central banks, investors follow CPI in China hoping for a rise. That’s because upward pressures on prices could indicate recently weak sentiment and sluggish activity on the part of consumers might be turning a corner, pointing to a return to growth and a rebound in its stock market, down almost 7% YTD as of last Friday.

Prices point to weak economy
On the face of it, consumer inflation sent just such a signal last Monday, when China’s National Bureau of Statistics reported August CPI tallied a 0.6% year-over-year increase. Despite that falling short of economists’ estimate of 0.7%, it was an improvement over July’s 0.5% year-over-year rise, and the most annual progress witnessed since February. Unfortunately, producer prices released last Monday showed a 1.8% slide in PPI year-over-year, far worse than the 1.4% consensus estimate, not to mention the 0.8% drop one month prior (see below).

In fact, even the seemingly decent headline CPI was something of an illusion, as food prices jumped 2.8% year-over-year in August due to heat and rain. Core CPI fell from 0.4% in July to 0.3% in August, marking its lowest since March 2021.

Trade points to soft demand
Taken together, such data points to extremely weak consumer activity and excess production capacity. That’s consistent with the type of stimulus China has seen over recent years, focused more on boosting manufacturing, with little support for consumption. Trade data released last Tuesday by China’s Customs agency pointed to the same trend: exports rallied 8.7% year-over-year, while imports grew just 0.5%, short of the 2% economists expected and miles off of last month’s 7.2% increase.

Demand stimulus seems a must
In our view, strong exports may serve to distract from China’s languishing domestic economy. In fact, exports are probably exaggerated due to front-loading of shipments by producers trying to get ahead of escalations in trade tensions. A soft landing for the global economy would likely keep outbound trade going strong, which helps to support sagging growth, though we believe policymakers will need to make greater efforts to stimulate demand—programs encouraging consumer trade-ins, for example—before there can be real progress in turning China’s economy around.