Could the Federal Reserve turn more dovish?

Uncertainties around the U.S. fiscal impulse in the medium term, set against the backdrop of the upcoming 2024 elections, could keep inflationary pressure somewhat elevated.

We have witnessed arguably the most aggressive monetary policy tightening cycles in the U.S. since the Great Inflation of the 1970s. The good news is that headline inflation in the U.S. has come off its 9.1% peak in June 2022 to 3.7% in September 2023. This is still some ways away from the Fed’s target of 2%, consistent with its mandate of maximum employment and price stability.

With the Fed still focused on inflation, it is worth considering what could push prices higher and prevent the central bank from adopting a more flexible stance.

First, looking under the hood of the consumer price index (CPI) reveals some pockets of price pressures. This is evident in the uptrend of Fed Chair Jerome Powell’s “super core” (core services ex tenants’ rent and owners’ equivalent rent) CPI measure. While adjusting for one-off factors, such as a surge in mass transit prices, shows a moderation in the underlying super core trend, a reacceleration could keep the Fed on guard. 

Second, absent an improvement in long-term productivity, the tight labor market in the U.S. could keep wage growth elevated, hence keeping upward pressure on core CPI.

Third, uncertainties around the U.S. fiscal impulse in the medium term, set against the backdrop of the upcoming 2024 elections, could keep inflationary pressure somewhat elevated, adding further complication to the Fed’s already difficult task. Should these factors stay persistent, the Fed may find it difficult to cut rates in a meaningful way.

Following the end of the pandemic, the Fed embarked on quantitative tightening (QT) in a bid to shrink its balance sheet after purchasing significant amounts of U.S. Treasury (UST) bonds and mortgage-backed securities (MBS). Our central scenario is that QT moves as planned with the Fed drawing down its balance sheet by an orderly USD 1trillion per year. The risk to our view centers around the intersection of the Fed’s QT and the looming supply of UST securities to fund a near USD 2trillion federal deficit next year. 

Exhibit 2: 

Source: FactSet, U.S. Bureau of Labor Statistics, U.S. Federal Reserve, J.P. Morgan Asset Management.
Data reflect most recently available as of 30/09/23. 

 

All told, our baseline is for inflation to be well behaved with the likelihood of the Fed cutting rates only in 2H 2024, in line with prevailing market expectations. In this scenario, investors could consider locking in higher yields for capital appreciation.

However, if inflation surprises on the upside, investors should look toward inflation-hedged assets such as real estate and commodities that could provide income.