12/12/23, 9:35 PM Three rate-cut questions for the Fed

Unhedged Federal Reserve

Three rate-cut questions for the Fed
And are we in a profits recession?

Federal Reserve chair Jay Powell speaks on Wednesday © FT montage/Bloomberg

Robert Armstrong & Ethan Wu 8 HOURS AGO

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Good morning. All quiet to start the trading week. With the holidays imminent,
Unhedged’s idea hopper is running on empty. Help us replenish it:
robert.armstrong@ft.com and ethan.wu@ft.com.

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12/12/23, 9:35 PM Three rate-cut questions for the Fed

What we would ask Powell at Wednesday’s presser

Unless today’s inflation data is ferociously hot, the market consensus on a soft
landing and 2024 interest rate cuts should remain intact. But even though some
observers think the hard part is over, the Federal Reserve does not. Its job, in many
ways, is harder now. In the words of chair Jay Powell, risks have become “more
balanced”, Fedspeak for “the job market deteriorating is now a similarly scary
prospect to inflation re-accelerating”. When inflation was running wild, smashing
the higher-rates button with maximum vigour was the clear call. Now, more finesse
is needed to secure the soft landing.

Signalling has a powerful impact on markets, so the Fed is understandably tight-

lipped about how rates might fall, with one exception. As we discussed at the time,
Fed governor Chris Waller said in late November:

If we see disinflation continuing for several more months — I don’t

know how long that might be, three months, four months, five
months . . . you could then start lowering the policy rate just because
inflation’s lower . . . It has nothing to do with trying to save the
economy. It is consistent with every policy rule. There is no reason to
say we will keep it really high.

This sort of policy normalisation, lowering nominal rates to hold real rates steady
as inflation falls, makes sense. But there are loads of questions around how it will
work in practice. Here are three we are thinking about.

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12/12/23, 9:35 PM Three rate-cut questions for the Fed

1 As inflation falls, what principles will guide policy

normalisation? The Fed’s nightmare is stop-and-go rate increases
reminiscent of the 1980s. That is the biggest reason to wait to
normalise rates. In the milder case of the mid-1990s, the central bank
cut rates after an uptick in unemployment, and eventually had to raise
them again when the economy strengthened. In a note over the
weekend, Morgan Stanley’s Seth Carpenter called that episode a
“cautionary tale”. But equally, it is possible to put off cuts for too long,
as the Fed did in 2007. Unemployment is non-linear; once it’s rising
unambiguously, it’s often too late.

In a recent report, Skanda Amarnath and Preston Mui of Employ

America offer three principles for rates normalisation: once cuts start,
they should be front-loaded, proportional to inflation and data-
dependent. Front-loading delivers a powerful dose of looser financial
conditions right away, doing the most to counteract the risk of rising
unemployment. Proportionality (eg, 1 per cent lower inflation rate = 1
per cent lower policy rates) gives the Fed and markets clear guidance
for how fast to proceed. Lastly, data-dependence lets the central bank
maintain optionality, in case inflation resurges or falls faster than
expected.

2 What sort of inflation counts? Fed officials have said they want to
see moderation in each of three inflation categories: goods, rents (the
biggest category) and non-housing services. The reality of falling
inflation and/or rising unemployment might change that. Prices of
non-housing core services make up less than a quarter of the total
inflation basket, and some, such as auto insurance, have been
unusually, persistently hot. Would inflation in a few services categories
keep the Fed from lowering rates even if unemployment was inching
up and core inflation falling? Either way, “we have to have more clarity
about what [types of inflation the Fed] is comfortable with”, says Kevin
Gordon at Schwab.

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12/12/23, 9:35 PM Three rate-cut questions for the Fed

3 Is it really full-steam QT for ever? Quantitative tightening

(shrinking the Fed’s balance sheet) is a form of normalising monetary
policy, Powell has said, meaning that rate cuts and QT could well go
together. This has not always been the case. In 2019, while it was
cutting rates, the Fed was forced to restart bond purchases because of
chaos in the repo market. That came just months after Powell said QT
was on “autopilot”. Some money-market watchers think the Fed will
slow the pace of QT pre-emptively to buy itself time. Serious market
dysfunction could kill off QT.

A recession could, too, or perhaps even a slowdown threatening to

become a recession. Deutsche Bank’s US rates strategists argue that if
the central bank is bent on “actively easing policy, it will end QT. This
view is driven primarily by the communications challenges the Fed
confronted in 2018-2019 around the prospect of having its two tools
work at cross-purposes — that is, easing by cutting rates while
tightening through balance sheet run-off”. In any case, we need a
better sense of the Fed’s QT reaction function.

We’ll be keeping an ear out as Powell speaks on Wednesday. (Ethan Wu)

Are we in a profits recession?

A little while ago Bloomberg published a short piece which has stuck in my mind
ever since. The article, “Without top five stocks, S&P 500 is deep into profits
recession”, contained this passage:

Without its five largest names, the S&P 500’s quarterly EPS has fallen
1.5% in 3Q y/y, according to Bloomberg Intelligence — even with better
than expected results. Compare that with the index’s overall growth
rate of 4%

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12/12/23, 9:35 PM Three rate-cut questions for the Fed

I was a little surprised by this, given how strong the economy was through the end
of the third quarter. And it got me thinking about how much we should care if we
are in a profits recession. The point of the Bloomberg piece, as I understood it, was
that outside of the five biggest companies by market capitalisation (Apple,
Microsoft, Amazon, Alphabet and Nvidia) S&P 500 profits are falling, and this
should make us wonder about the sustainability of the current rally. But it also has
implications for the economy: it likely reflects something about the ability of
companies to raise prices, pay workers, invest in new projects and so on.

I did a little measuring myself, but differently from Bloomberg in two ways. First, I
used sequential rather than year-over-year changes in earnings. I wanted to match
the way we talk about economic recessions, for which the common narrow
definition is two quarters of sequential declines in output. Sequential change is also
a more immediate measure of economic momentum (though it does create the risk
of seasonal distortion). And I also used net income, or more precisely net income
adjusted for unusual items, rather than net earnings per share (my numbers come
from S&P Capital IQ). I wanted to look past the effects of stock buybacks on EPS,
so I could see changes in companies’ underlying profitability without the impact of
changes to capital structures.

Looking in terms of sequential changes in net income, we are not in a profits

recession, but we are close. While earnings fell 4 per cent in the third quarter, they
rose 1 per cent in the second. Following Bloomberg, what about taking out the five
biggest companies? That does appear to put us into a recession, with earnings
growth down 8 per cent in the third quarter and 1 per cent in the second. But this,
it turns out, is a distortion: in the third quarter, the eighth largest company in the
index, Berkshire Hathaway, reported a big net loss because of changes to the value
of its investment portfolio (Berkshire likes to put these changes aside when talking
about its profitability). Take Berkshire and the top five companies out, and S&P
earnings grew a plump 6 per cent in the third quarter; adjust for a large non-cash
charge at Walmart, and growth is a point or two better still.

The data is fiddly, and there is not a canonical answer to the question “is US
corporate profitability rising or falling?”. The closest thing is probably the national
accounts compiled by the Bureau of Economic Analysis; these also show modest
but positive sequential growth in profit after tax in the past few quarters.

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That said, another way to see that we are not in a profits recession: only 68
companies in the S&P had profits fall sequentially in both of the past two quarters.
The list of companies in “profit recession” contains companies from 10 of the 11
major sectors (communications services was the exception), but there was not an
obvious or menacing macroeconomic pattern to be found in the list, other than a
few sectoral trends (eg, transport companies are struggling; liability-sensitive
regional banks are under margin pressure).

Profits, like the economy, are slowing. But we are not, however you slice it, in a
profits recession.

One good read

One of the FT’s best takes his bow.

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