Pro Perspectives 11/7/23





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November 07, 2023

Since the Fed meeting last week, the 10-year yield has fallen by as much as 45 basis points, the market has priced out the chance of a December hike, and is now pricing in a coin flips chance of 100 basis points in cuts by the end of next year.
Remember, last Wednesday, Jerome Powell acknowledged that "financial conditions had tightened significantly in recent months, driven by higher longer-term bond yields, among other factors (like lower equity prices and a stronger dollar).  
But he also made it clear that these conditions would need to persist, to sideline the Fed.  Of course, markets have since moved.
With that, the Fed deployed a media blitz today, with an army of speakers, intended to plant some seeds of doubt in the market, on whether or not the Fed is indeed done hiking rates. 
The verdict?  Markets weren't buying what Fed officials were selling.  Yields finished down on the day, stocks finished up.
Let's take a look at another reason we should believe the Fed is done with this tightening cycle.
This chart below shows the current effective Fed Funds rate, along with the Fed's projected path, all in orange.  In blue, we have the current inflation rate (the Fed's favored core PCE), along with the Fed's projected path for inflation.  The data is from the Fed's September Summary of Economic Projections (here). 
Now, the difference between the Fed Funds rate and inflation is the "real interest rate" (black numbers in the above chart).  The real rate puts downward pressure on inflation and the economy.  And as you can see, it's currently 1.6%. 
And you can see on the right side of the chart, the Fed, itself, projects the long-run real rate to be 0.5%.  
Clearly, at 1.6%, conditions are very tight, relative to the Fed's view on the long-run real rate. 
This is where the visual is striking. We have a Fed that's contemplating, at the moment, whether or not it's too tight.  Yet, if we look at their forecasts through 2025, they are projecting to be even tighter (an even higher real rate, circled in blue) than the current real rate.
The takeaway:  To avoid getting tighter, as inflation continues to go the Fed's way (lower), they will have to cut rates.
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