Nothing Is Obvious

Michael Grant

Summary Points:

• Pivots by central bankers are typically positive for financial asset prices, but the Fed’s forecasts have been miserably wide of the mark.
• 2024 will be different from 2023 because the balance between inflation, disinflation and the rising possibility of deflation is more nuanced.
• The revived bullish mood is likely climaxing now. We see little upside for the S&P 500 beyond January and into the election.

2023 was an uncommon year. The US economy turned out to be much stronger than most forecasters expected, equity returns were dominated by the so-called Magnificent 7, the rebound of cryptocurrencies implied speculative liquidity remains abundant, and interest rate volatility was the highest since the Global Financial Crisis. To cap this, the Federal Reserve wrote itself an impressive encore in December that surprised many.

Pivots by central bankers are typically positive for financial asset prices, and investors have learned as much. However, Powell’s deterministic influence on markets in the absence of any economic breakage has raised eyebrows. The end of deflation created the conditions for the Federal Reserve to leave center stage and let other factors play the leading role in determining asset prices. Instead, it feels as if the impulse for interventionist central banking remains a prevalent part of the financialized welfare state.

Chair Powell did highlight a dramatic change in thinking about the 2024 outlook. Not only has US inflation declined rapidly, but the Fed’s Beige Book survey of regional economic conditions drawn from businesses around the country points increasingly to moderating activity. On the other hand, the Fed’s preferred index of inflation, the core personal consumption (PCE) expenditure deflator was still rising 3.5% in October, substantially above the 2% target. What happened to looking at the “totality of the data?”

Powell did insert the caveat that further rate increases could still be required, perhaps reflecting the reality that the Fed’s own forecasts have been miserably wide of the mark. That so many forecasters have underestimated the resilience of the US economy implies they may still not see what is actually driving events. And yet, confidence is high that the inflation dragon has been slayed. Amidst all of this, Powell suggested that quantitative tightening (QT) would continue even after the Fed gets to the point of actually reducing its policy rates.

Some suspect the “Christmas Pivot” was politically motivated, and in one peculiar sense, this may be correct. By raising interest rates paid on excess reserves held by commercial banks in their accounts at the central bank, the Fed’s interest expense rises by ~$30 billion per annum for each 100-basis point rise in the policy rate. This sharp rise in expenditures adds directly to the fiscal deficit by reducing the profits that the Fed has been remitting to the Treasury since it commenced its Quantitative Easing (QE) program under Bernanke.

This dominance by the Fed’s unelected technocrats over what is considered the citizens’ remit could become an election issue, especially when both parties’ current frontrunners are populists. Some will wonder if a central bank that is directly impacting the nation’s finances can be allowed to remain independent if there is no way for voters to influence its decisions. In this light, Powell is purchasing valuable time. The economy needs to stay out of trouble long enough so that the remaining few trillion dollars of excess reserves can be mopped up as quickly as possible.

The Fed may therefore have no more insight into 2024 than the rest of us, but its political underbelly needs to ensure that “Fed independence” does not become part of the political debate. The wild card remains the inflation dynamic that could boomerang on the Fed. Key shortages in labor and housing point to sustained demand, with greater-than-usual financial flexibility across the private sector. This contrasts with the Fed’s prior mantra that it would not relent until economic growth moved below trend in a sustained fashion.

If 2023 can be summarized simply as a year of disinflation amidst a resilience economy, how might 2024 unfold for investors?

The script has flipped from a year ago. 2024 will be different because the balance between inflation, disinflation and the rising possibility of deflation is much more nuanced. Meanwhile, a broad consensus is coalescing around immaculate disinflation amidst a soft landing or no landing for the economy. The latest rally in equities and bonds has eased financial conditions and reduced the likelihood of imminent policy easing, even as this rise in risk appetite is being partly fueled by rising expectations of such.

Of course, Powell could be proven right in his outlook and his actions—even the blind squirrel finds a nut. We suspect the revived bullish mood climaxes in January, giving way to a (possibly hard) consolidation into spring as the varied moving pieces that underpin these debates lead to investor skittishness. We see US economic growth, inflation, and monetary policy all proving “sticky” through H1, pointing to little upside for the S&P 500 Index beyond January and into the election.