How is the Fed going to cut rates with inflation over 3%?

[ratiman]

According to the CME Fed tracker, there is a minuscule chance (.3%) that the Fed rate stays flat through December.

 

https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

 

This doesn't make any sense to me. Right now nominal GDP is higher than the Fed rate (5.25%). If inflation is ~3%, economic growth is ~2-3%, then Fed rate is below NGDP. Trailing NGDP growth is at 6%. How can it be virtually GUARANTEED that the Fed will cut when Fed has not brought inflation to 2% and the rate is not restrictive? Plus we see oil and copper and trucking and gold are taking off. I don't get why the rates market and Fed are so dovish. The chance the Fed stays flat should be at least 5-10%.

Edited March 23 by ratiman

[RichardGibbons]

Yeah, I've wondered about this too, and don't have a good answer.

The best I've come up with is that there's stuff that increases measured inflation when interest rates go up.  (e.g. in Canada, if mortgage rates go up, it increases the rate of inflation.)  I wonder if there's enough stuff like that in the measurement that people can be quite confident inflation will fall over the next six months if the Fed stands pat or lowers rates.

[ratiman]

I think there is a widespread expectation that we are going back to disinflation. Disinflation was underestimated in the 80s and 90s and today inflation is being underestimated. 4.2% seems like not nearly enough to compensate 10 year bondholders for the risk of inflation. If Donald Trump becomes president does anybody think he is going to put the gov't on a diet? Does he look like that kind of guy? The handful of deficit hawks are vastly outnumbered not just in congress but even among Republicans.

 

The Fed signaling they are about to cut will paradoxically make it much harder for them to cut.

[Gregmal]

So much of the current “inflation” people are talking about is because of the heavy weighting in housing related inputs. And housing is elevated because of rates being high. Ex shelter we re probably sub 2%. 

[ratiman]

The housing market has been consistently undersupplied since GFC. Only borrowers with pristine credit scores could buy homes and NIMBYs in coastal cities have also impeded housing supply. There is a huge bulge of millenials buying homes and not an adequate supply so I don't see rent or housing prices slowing down. Once people start stripping components out of inflation it starts to sound like a rationalization. Inflation is like heating up a pan of pop corn, the pan is getting uniformly hot even if not every kernel is simultaneously popping.

[Gregmal]

IDK...Ive just always thought, at least since this whole saga began, the steady state new norm is like 3-4% inflation with some inconsequential noise occasionally. That kinda works for everyone. The bigger thing in housing is that the FED is the reason its currently weighing in where it is. So I suppose the important read here is whether housing prices reaccelerate if rates come down, or if merely it allows more supply to hit the market at or around current pricing? Whatever it is, the lag is gonna require 12-18 months to get answers on, and as always, the market will price it in well before that. 

[tede02]

It doesn't look like price pressures on housing is going to ease in the immediate future but this caught my eye last week. Multi family construction has jumped to the highest level in 50 years and single family, though not at highs, is trending in the right direction. Probably takes a few years for this new supply to effect supply/demand balance. 

 

I also don't understand why the Fed board is talking up rate cuts. Financial conditions have eased substantially this year. The markets are wide open again with fresh IPOs and tightening spreads. It's kind of crazy. Feels a bit like 2021 again. If I were a member of the FOMC, I'd be really concerned that inflation will pick up materially if they cut rates. It also seems like the markets are really vulnerable to the Fed coming out and saying they aren't going to cut this year. 

 

One thing that does make me chuckle a little is despite all the gloom and doom in commercial real estate, the sector has been fortunate that the rest of the financial markets have been booming. Distressed sales seem to still be the exception rather than the norm. I'm sure it would be a very different situation if the economy was in recession, markets were down, etc. Who knows what happens in 2025 but it seems like CRE has been gifted a very favorable backdrop to muddle through for now. 

[changegonnacome]

54 minutes ago, Gregmal said:

So much of the current “inflation” people are talking about is because of the heavy weighting in housing related inputs. And housing is elevated because of rates being high. Ex shelter we re probably sub 2%. 

 

Reminder that all the Fed and Fed watchers talk about really is Core PCE which strips out housing completely......its Core PCE spiking upwards and re-accelerating at a rate not seen since 2022 over recent months that's popped a wrench in six cut blue sky scenario....this is domestic inflation in goods and services but mainly services for obvious reasons.....everything else that gets on shipping containers is or has leveled out or outright deflated.

 

4 minutes ago, Gregmal said:

the steady state new norm is like 3-4% inflation with some inconsequential noise occasionally.

 

Kind of agree - the Fed's passivity in the face of recent upticks in Core PCE MoM data is a small tell (without them telling) that perhaps this Fed willing to let things run hotter than usual......nice explanation is that they are thinking about lag effects and the second part of their dual mandate employment more deeply these days.......unkind explanation is that 3-3.5% inflation is kind of a politically acceptable inflation level that wouldn't interfere too much with an incumbent presidents re-election campaign......whereas spiking unemployment & negative GDP prints would......their forecasting of possible rate cuts in late 2023 was an effective easing of financial conditions which was eerily convenient timing for the start of Uncle Joe's 2024 re-election campaign.

 

Anyway getting a bit conspiratorial there - its not a crazy thing, in a way, for Powell / Fed to not want to tip the scales either way......right now the Fed has an actually tight fed funds rate while also talking explicitly about a lower rate later.

[Gregmal]

I actually really enjoyed Kuppys latest blog on how it framed a lot of the noisier market participants out there today. The pod shoppers. So true and so accurate how these snake oilers operate and what they look to do.

 

As it relates to this subject, I think inflation is firmly in the 2.5-4 range and not really going up much or down much…rates will gradually grind lower, but it will play out over several years, not quarters. You kinda just want to take the 30,000 foot view that this is the environment you’re playing in. What you don’t want to do is fall for the subscription sellers and snake oilers at the pod shops into extrapolating these arbitrary short term fluctuations like “CPI came in at .3 vs .2 which is 50% higher!!!!!”. Or that “inflation is still 40% higher than their mandate and this month we reaccelerated!”(with implications it’s headed back to 2022 levels but no commitment to a firm number mind you).

We saw how all this played out when we had real issues back in 2021 and early 2022 and these guys got left in the dust and now theyre pissed they look like idiots with SPY at ATHs…just focus on the bigger picture and play in the playground that’s most fun. Fun for me is making money. Not selling people subscription or getting followers and liked tweets. There is plenty of stuff that’s just gonna print money in a 3-4% inflation, 4-5% FFR environment. 

Edited March 23 by Gregmal

[RedLion]

So all the comments in this thread beg the question…is it time to buy duration TIPs? If we expect cuts plus increased inflation it seems they could do well. 
 

I’ve personally put most of my money into the longest duration TIPs of all, residential rental housing. 

[changegonnacome]

7 hours ago, Gregmal said:

We saw how all this played out when we had real issues back in 2021 and early 2022 and these guys got left in the dust and now theyre pissed they look like idiots with SPY at ATHs

 

If we are accepting a world of persistent 3-4%....its a world where you really need to start actively inflation adjusting things over periods that you never would have before.

 

Inflation compounds like returns......but not in a good way......it stacks on top of last years inflation.....for example SPY's Dec 2021 ATH was at ~4750......but thats in old money.......in real terms SPY to stay FLAT since Dec 2021 in real terms has to get to where we are something more like ~5200.....as purchasing power is all that ultimately matters......the gains are certainly welcome but the index equity investor is running to stand still against inflation headwinds. Exlc. dividends they haven't made a dime of real money in fast approaching 2.5yrs

 

In fact the ATH needed in real terms to get back to break even in purchasing power according to BLS calculator is 5287 on SPY so were basically there but not quite there yet:

 

 

I think about SPY only when thinking of the average Joe out there - inflation is unknowingly chipping away at his/her real wealth and is really acting like a federal tax on their future purchasing power which allows the beltway folks to keep acting irresponsibly.....its a cowards way of raising taxes/dealing with the debt/deficit and thats exactly what they are doing......obviously you and I dont mess around with the indexes so whatevs .......but for Mr & Mrs W2/vanguard 401k & IRA out there however, IMO, they are unwittingly having their retirement finery eaten by inflation moths while CNBC tells them the stock market is on the tear & Joe Biden tells them things have never been better.......obviously less clickbaity to tell the truth which is the market has been flat in real terms for nearly 2.5yrs now (QQQ is the same, flat, if you run the numbers from its Nov 2021 ATH and were suppodely in an AI bubble  so it took a bubble to get QQQ back to ATH's in real terms   ).

 

 

Edited March 23 by changegonnacome

[Gregmal]

50 minutes ago, changegonnacome said:

its a cowards way of raising taxes/dealing with the debt/deficit and thats exactly what they are doing

So the easiest solution and path of least resistance also happens to be the most convenient….why wager on anything else happening? 
 

What’s nice now IMO is you also firmly have the Fed put in hand. Remember the “they’re trapped and MUST follow their mandate!!!” by the people trying to cause a panic? Except today, you don’t even need real economic calamity…it’s pretty obvious that first sign of a hiccup they’re slashing and dashing. 
 

So to me, it’s probably not a super popular view, but I think we re kind of in a win/win as long as you’re not playing the quarterly numbers game. I’ve got my good old reliable core but have added positions recently in more torquey stuff like Citi and LPX which should spin nicely off of the new normal. VAL warrants I’ve added to as well. There’s too much stuff that still just isn’t priced for a normal outcome but everyone’s missing it because they’re trading bitcoins and crying that Nvidia is overvalued.

[ratiman]

So Powell comes out and says what everybody is realizing, that current rates aren't very restrictive, and now Fedwatch has Fed staying flat through December at . . . ZERO. Not .1% but actually 0%. I'm clearly missing something. Isn't the first rate cut the hardest, because it commits the Fed in one direction? If the Fed stays flat it leaves open the option of hikes without flip flopping. There must be something else going on because cutting with everything at highs and oil perking up and so on strikes me as insane.

[RedLion]

On 3/23/2024 at 5:09 PM, Gregmal said:

So the easiest solution and path of least resistance also happens to be the most convenient….why wager on anything else happening? 

This is my investment philosophy. It’s very rare that we will do anything but the path of least resistance. At this point it means massive deficit spending, above 2% inflation, and real wage gains. 

[Gregmal]

Just now, RedLion said:

This is my investment philosophy. It’s very rare that we will do anything but the path of least resistance. At this point it means massive deficit spending, above 2% inflation, and real wage gains. 

Yea idk. It just seems so obvious at this point that the whole “what’s the Fed gonna do” and “how many rate cuts/increases” game is a fools game. Remember SPY 3000?

[Sweet]

I don’t think they have a problem cutting rates at 3%.  I hope they don’t cut too much, rates were way too low 

[mattee2264]

It is easy to see why Fed will cut rates at the first opportunity:

 

-They want to get Biden re-elected

-The government has huge amounts of debt to service and lower rates and a period of financial repression makes that a lot easier

-There is a looming commercial real estate crisis as so many loans are underwater and they will want to avoid politically unpopular bailouts 

-Consumers are hooked on debt e.g. mortgages, credit cards and are suffering 

-Lots of companies will struggle to refinance cheap debt refinanced during the pandemic 

 

Disinflation stalling at around 3% is a minor inconvenience to them. And they can still claim that if they reduce by 75bps (the 3 cuts pencilled in) that policy is still restrictive and real interest rates are positive and they can explain away hot economic data by saying it is in the rear window and they see weaknesses in the economic outlook

[gfp]

The number one reason to consider cutting short term interest rates is that they didn't work as intended to slow the economy or reduce inflation.  They used to work slightly better by pulling back on the creation of new bank money creation into the economy but that indirect dynamic has been overtaken by the fiscal effect of t-bill interest increasing deficit spending stimulus.

 

The best reason to stop doing something is that you realize it isn't working.

 

If the government is really concerned about inflation it isn't all that hard to figure out how to tackle it (moderate fiscal deficit stimulus as a percentage of GDP).  But it won't involve the Federal Reserve except indirectly through their policy rate's influence on government interest expense / deficit.

 

I will add, like a broken record, also, that QE and QT are not effective tools and accomplish almost exactly nothing (and have several dynamics that are more effective in the opposite direction than the way they are used and commonly understood).  The Federal Reserve is not the agency with the toolkit for this issue. 

[Gregmal]

37 minutes ago, gfp said:

The number one reason to consider cutting short term interest rates is that they didn't work as intended to slow the economy or reduce inflation.  

I think this is such an awesome underlying aspect that really helps separate and categorize a lot of market participants. One thing was so obvious this entire time and that is that the “raise rates to fight inflation” thing just wasn’t really applicable to the majority of the “issues” over the past 3-4 years. Rates had and have very little impact on anything, and it’s only the academics that kept thinking we needed another hike after every monthly CPI print.

 

If nothing else, the reckless rate hikes just added probably 3-5 years to a housing bull market that was already due to run for most of the next decade. Otherwise, a monkey could see 3/4 of the “inflation” was really just supply chain related and then most of the 25% that wasn’t was housing related and only exacerbated by higher rates. Nevertheless we still hear the same old folks going off about hikes and cuts and the money supply and all these textbooky talking points and thankfully, much of the Fed falls into that camp and it’s why it’s been so easy to dance around this theme and exploit it. 
 

Basically the TLDR; so much of the market deeply desires the market to be predictable and fall in line with what the textbooks told them, and when it falls outside those bounds, they insist on still trying to quantify if within that framework, even though the new framework isn’t exactly that hard to apply…it just simply requires being capable of thinking outside the box.

Edited March 31 by Gregmal

[scorpioncapital]

isn't this what financial repression is? The rate of interest below the rate of inflation. Negative real rates. Some very smart analysts like Russell Napier, Justin Trennert and Larry MacDonald all think this is inevitable. Arguably Japan did not even scratch the surface, with real rates perhaps 0 to -1% is very mild for a very indebted society. Add capital outflows or lack of investment and it seems we need negative rates that are far lower than even -1%? So how does gov achieve this without 'scaring the horses' to run as Napier says. One way is to fake the CPI stats and create a deception so that inflation is higher and rates are lower than that actual number. Another way is populism. Restrict economic activity or who is forced to hold government debt. 

[Paarslaars]

6 hours ago, Gregmal said:

I think this is such an awesome underlying aspect that really helps separate and categorize a lot of market participants. One thing was so obvious this entire time and that is that the “raise rates to fight inflation” thing just wasn’t really applicable to the majority of the “issues” over the past 3-4 years. Rates had and have very little impact on anything, and it’s only the academics that kept thinking we needed another hike after every monthly CPI print.

 

Exactly, they might realise this by now but are slowrolling the rate cuts to save face...

[LC]

8 hours ago, scorpioncapital said:

Another way is populism. Restrict economic activity or who is forced to hold government debt. 

Another way is debt forgiveness- forced or voluntary. 

[Eldad]

I mean cynically the Fed has an election to win so it doesn’t really matter what inflation is doing. 
 

Look at the crazy rise in the gold price. Gold market is saying inflation will stay elevated but they will cut anyway. 

[scorpioncapital]

how can the Fed - or for that matter how did Japan control interest rates if inflation was higher than the rate? If the government is buying the bonds is the idea that there is a long time before they own 100% of the market, after which it is no market at all? Any effect on the currency?

[Gregmal]

I actually think, although haven’t thought too heavily, about how decent a hedge trade it would be to go long an obnoxious amount of like 20 year treasuries on margin. 
 

Right so buying puts is generally a sophisticated white collar guys way of throwing money in the garbage. Shorting as well is largely a fools game. But if I can borrow/margin at 6-7%, while getting paid 4.5%, what’s my upside and what’s my downside? 
 

The never relenting “inflation fanatics” who have seen inflation everywhere for much of the last decade or so still see it, and after nearly two years of monthly declines in the data we get an expected hiccup or two…no it doesn’t mean we re heading back to 5-10%…but it’s given us a neat setup as a few of the fringe participants start leaning on the very short term data because gee, if we can’t trade or gamble on every daily or weekly theme…whats the point? 
 

So really, if I go long a monstrous amount of the 20 year treasury, maybe I assume 10-15% upside risk if we run back to last years highs which were basically just a well timed Ackman pump? Plus the margin rate minus the interest so call it another 3? But if shit hits the skids….Fed drooling to cut. Could we hit 30-50% upside? Definitely think so. 
 

So a heads I’m hedging and not losing much and my longs soar on more good data, tails I have a hero trade on my hands at de minimus cost….