A Fed hawk hints at cuts

Bond yields tumbled after Christopher Waller, one of the Federal Reserve's most influential and hawkish governors, said the central bank could start lowering rates if disinflation carried on for several more months. Interest rate futures promptly priced in more than 100 basis points of easing for 2024. Markets tend to sit up when a hawk mentions cuts.

Why this voice mattered

Mr Waller was among the firmest advocates of the rapid rate rises of 2022. When a governor with that record starts describing the conditions for a cut, traders reasonably assume that the centre of the committee has moved too. As a governor he votes at every meeting, unlike most of the regional bank presidents, who rotate through voting seats, so his view counts directly towards the decision. Short-dated Treasuries, which are the most sensitive to the policy outlook, are where such a shift shows up first. The speech also landed in a market already primed by softer inflation data and a bond rally that had run through November.

From 5 per cent to a rally

The setting explains the force of the reaction. The Fed lifted its policy rate from near zero in March 2022 to a range of 5.25 to 5.5 per cent by July this year, the fastest tightening since the early 1980s, and has held it there at its September and November meetings. In late October the ten-year Treasury yield briefly touched 5 per cent for the first time since 2007, as investors braced for rates to stay high for years.

November then turned the mood. The Treasury raised its sales of long-dated debt by less than dealers had expected, employers added a modest 150,000 jobs in October, and consumer prices were flat that month, leaving the annual rate at 3.2 per cent. Each release chipped at the case for another rise. Mr Waller's remarks gave the rally something it had lacked, a respectable argument from inside the Fed for where rates go next.

Waller's arithmetic

His reasoning was hard to fault. If inflation keeps falling while the nominal policy rate stays at 5.4 per cent, the real, inflation-adjusted rate rises by itself and financial conditions tighten without the Fed lifting a finger. To keep policy restrictive without squeezing harder, the Fed would need to lower nominal rates roughly in step with inflation. A cut made to hold real rates steady is routine upkeep, and calling it stimulus would be a stretch.

The numbers make the point concrete. With core consumer prices up 4 per cent on a year earlier in October, a policy rate of 5.4 per cent implies a real rate of well over one percentage point. If core inflation drifts towards 3 per cent over the coming year and the Fed does nothing, the real rate climbs past two points, tighter than almost any estimate of the neutral level. Standing still would then amount to a series of unannounced rate rises.

There is a measurement wrinkle. Deflating the policy rate by the past year's inflation is backward-looking, and what matters for borrowers is the rate relative to inflation they expect. Surveys and market-based measures of expected inflation have fallen more slowly than actual inflation, so the real rate borrowers perceive may be rising less quickly than the simple sum suggests. That argues for patience over the timing of the first cut, while leaving the direction of travel intact.

A precedent from 1995

The Fed has done this before. After doubling its policy rate to 6 per cent between early 1994 and early 1995, the Greenspan Fed began trimming it in July 1995 as inflation settled, and the economy went on to one of the few soft landings in the central bank's history. Those cuts were small and were presented as adjustments to stop policy tightening by default, which is close to the case Mr Waller is making. In 2019 the Fed made three similar mid-cycle cuts, though inflation then was below target rather than above it.

Why the Fed may hold back

The case against is that inflation has fallen before and bounced back, and the Fed's credibility suffered badly when it called the 2021 surge transitory. Core inflation is still about double the 2 per cent target, unemployment remains below 4 per cent, and wage growth is still running ahead of what 2 per cent inflation would allow. There is a subtler risk too. The more cuts markets price, the further long-term yields and mortgage rates fall, which loosens the very financial conditions the Fed has worked to tighten.

The winners from the repricing are easy to name. Holders of Treasuries have clawed back part of a bruising autumn, would-be homebuyers have seen mortgage rates edge down from their October highs, and small companies that borrow at floating rates can glimpse relief. Savers in money-market funds, who have enjoyed yields above 5 per cent, are the obvious losers if cuts arrive. Governments and companies in emerging markets that borrow in dollars gain too, since their refinancing costs track Treasury yields. The dollar itself is another loser, which tends to soften when American rates are expected to fall faster than those elsewhere.

What would change the call

The committee meets on 12 and 13 December and will publish fresh projections. In September the median official still pencilled in one more rise this year and a policy rate of 5.1 per cent at the end of 2024, and a lower path in the new projections would show that Mr Waller speaks for more than himself. The November jobs and inflation reports, both due before the decision, will show whether disinflation is still on course. A hot reading on services prices would push the first cut later.

Waller has handed his colleagues a respectable case for cutting in 2024. Easing can now be sold as upkeep of real rates, which spares the Fed the look of bowing to the market and makes a cut in the first half of the year more likely. Markets pricing more than 100 basis points are probably still ahead of the committee, and the December projections are likely to show fewer cuts than futures imply, but the argument over whether to ease has become an argument over when.