Issue 89: June FOMC Recap

This Week’s Highlights

• June FOMC delivers another hold
  Not surprisingly, the Fed elected at its June policy meeting to sit tight on rates, though the central bank’s language was still hawkish and quarterly dot plots now reflect only one reduction in the Fed’s benchmark rate for the year, suggesting there won’t be cuts until closer to year-end.
• May CPI a slight downside surprise
  Markets seemed more keen on the other big news to drop on Wednesday: May’s inflation figures, which showed US prices flat month-over-month, a little better than economists expected, and enough to keep traders’ hopes alive that we might get more action from the Fed in 2024.
• Economies of Asia on the mend
  Looking at PMI readings across emerging and developed Asian economies, it’s obvious much progress has been made since 2023, with surveys showing many markets jumping from contraction to expansion in the last few months as trade and domestic demand see a strong recovery.

The CIO’s Take:

• The Fed’s ‘wait-and-see’ stance—however rational it might be based on experience of a 1970s second wave—creates risk, in our view, of the bank falling behind the curve. If the economic softening we’ve started to observe gets away from them, a ‘soft landing’ narrative could morph into something less conducive to the current risk-on rally.
• With May’s CPI data seeming to kick Q1’s trend of a bounce back in price pressures, market odds of a September cut jumped from less than fifty-fifty to nearly two-in-three. That said, we don’t feel Powell and colleagues are setting the stage for a pivot by then; with an election looming on November’s calendar, we see just one cut in December.
• One differentiating feature of our portfolios is an active orientation toward international markets, including those in Asia, where there has been plenty of opportunity to play a rebound in economic activity as prospects for demand and global trade have improved. Especially in EM Asia, we think better conditions merit an overweight.

June FOMC Recap

Still waiting for the Fed’s pivot
Last week’s FOMC ended with a decision by the US central bank to keep its benchmark rate steady at 5.25–5.50%. That outcome was widely predicted, with CME Group data showing the probability of a June hold at 99.3% just before the FOMC concluded. Of course, as has often been the case since the Fed started raising rates just over two years ago, much more attention was on the Fed’s tone, as well as the bank’s Summary of Economic Projections (SEP), which comes out once per quarter and gives us hints as to where policymakers see the economy and rates trending.

Tone remains a little hawkish
Digesting reactions to the FOMC’s official statement and post-meeting press conference, our sense is the markets see Fedspeak as marginally hawkish. Powell made it clear that he thinks monetary policy is already restrictive, and not a single committee member is expecting more rate hikes at this point. On the other hand, despite referring to recent inflation readings as “getting good results”, Powell reiterated the need for more evidence of sustained disinflation, stating that “so far this year, the data have not given us that greater confidence.”

2024 dot plot shifts higher
Turning to the data in the Fed’s quarterly SEP, the big surprise was a median single cut for 2024 in the latest dot plot, down from three cuts projected in last quarter’s summary. Futures quickly adjusted to reflect higher year-end policy rates, continuing a trend toward pessimism around easing established months ago (see below). Of the 19 dots representing committee members’ forecasts, 11 landed on rate cuts beginning in December or later, reflecting a strong preference to wait before pivoting to accommodation.

We’ll have more to say on the FOMC’s inflation projections in a moment. In the meantime, staying with the dot plots, it seems to us that these data, combined with still-cautious language from Powell—a Fed chair with a reputation for messaging big moves ahead of time—suggests a high likelihood September won’t be the first cut. We see November as out, given a looming US Presidential election, which leaves December as the probable sole reduction in the Fed Funds rate for 2024. Possible wild cards? A sudden sharp downturn or an inflationary surprise between now and then.

Good News on US Inflation

May CPI softer than expected
We mentioned inflation projections above, and that’s an especially interesting case with the June FOMC. It’s not every Fed meeting that we find the committee’s convening coincides with a CPI report, but that was the case on Wednesday, as the US Bureau of Labor Statistics (BLS) put out May inflation figures in the hours before a Fed announcement on its June rate decision. According to the BLS, it was a good month, with US headline inflation advancing 3.3% year-over-year in May, lower than the 3.4% reported in April, and also a tick lower than economists had expected.

US prices unchanged since April
Things looked even better month-over-month, on which basis the CPI was actually flat in May. That was lower than the 0.3% rise recorded for April and slightly below consensus estimates, which called for a 0.1% increase in prices. Core CPI also came in lower than expected, up 0.2% monthly and 3.4% annually, versus forecasted increases of 0.3% and 3.5%, respectively. Markets shrugged off some negatives among the component data—shelter inflation increased 0.4% for the month, up 5.4% year-over-year—and traders bid stocks to big gains by Wednesday’s close.

Fed still fears another surge
And how about the Fed’s expectations for inflation in the aforementioned June SEP? It turns out members of the committee see inflation higher by year-end than they did when polled back in March, projecting core PCE inflation to finish 2024 at 2.8%, 0.2% above what they forecast three months ago. At Wednesday’s presser, Powell called the May CPI data “encouraging” and noted that higher SEP estimates bake in some conservatism to account for possible upside surprises. That’s understandable, as the Fed worries about a repeat of 1970s inflation playing out (see below).

We’ve seen versions of the chart above with axes contorted to make the two series almost perfectly overlap, but we don’t think that manipulation is really necessary. From the simple plot above, the Fed’s nightmare is obvious: Just over 50 years ago, CPI surged and fell, only to stall for some time and rocket up again, with a retreat back down to the Fed’s target taking more than a decade. Seeing progress on inflation flatten out at 3% in early 2024, one sympathizes with the sentiment we imagine is pushing FOMC members to opt for a ‘wait-and-see’ approach to easing.

Expect Fed to err on the safe side
Sure, we’ve seen the US economy apparently softening in the last two months, and a Q1 reacceleration of price pressures seems to have abated in April and May. That said, we don’t expect the Fed to take its foot off the brake too soon or bring rates down too quickly when they do start cutting. As the chart above cautions, we ought not rule out a period of more persistent inflation and a need for protracted restrictive monetary policy. For now, American consumers will simply take comfort in a mild May reprieve on groceries and gas going into the first month of summer.

Asia’s Economic Recovery

Developing Asian economies leap into expansion
With so much focus on the US economy, it’s easy to overlook what’s happening in emerging and frontier Asia. Because our portfolios are built to capture opportunities in other parts of the world, we like to pay closer attention. Along those lines, we have been tracking some of the manufacturing headwinds keeping Asian markets’ valuations down as Western demand flagged amidst central bank rate hikes. To see how that’s playing out in recent months, it’s worth taking a look at the latest Purchasing Manufacturers Index (PMI) readings across developing Asia versus those from last May (see below).

Recovery in factor activity continues
From the chart, it’s clear: the past year has seen a big recovery in manufacturing across some of Asia’s biggest developing markets, with May 2024 PMI numbers for China, Taiwan, and South Korea near two-year highs and firmly in expansion. Taiwan has witnessed the biggest increase in activity, with May’s growth in new orders the best recorded since December 2021, according to S&P Global, who cited domestic demand as lifting output despite soft foreign orders. In Vietnam and South Korea, by contrast, exports continued a recovery started in the first quarter.

Japan, Australia PMI also upbeat
And it’s not just developing markets: advanced Asian economies have also seen their manufacturing fortunes turn since 2023. In May, for instance, PMI survey data from Jibun Bank Japan revealed factory activity in the world’s fourth-largest economy expanding for the first time in a year, with increased job creation, greater stability in new factory orders, more robust production, and a favorable outlook. Meanwhile, Judo Bank Australia’s headline PMI, in contraction over most of the last year, ticked one notch closer to growth, rising from 49.6 to 49.7 in May.

Growth raises inflation concerns
One potential downside to the parade of positive PMIs is that growth in production typically comes with some cost inflation. Because manufacturers usually won’t be able to pass all of those extra costs onto consumers, that leads to an inevitable compression of profit margins. As companies raise prices to compensate, that inflation transmits to consumers, creating some uncertainty around the timeline for banks cutting rates. The Reserve Bank of Australia is in a particularly tricky spot, with persistent inflation and a real possibility of further rate hikes.