Pro Perspectives 1/16/24





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January 16, 2024

We're halfway through the first month of the New Year.  And it's already fast moving, with plenty of noise.
We had the Computer Electronics Show in Las Vegas last week.  And it was all about generative AI.
Remember, after the jaw-dropping Nvidia earnings last May, many called the boom in AI stocks unsustainable.  But they underestimated the significance of this technological revolution.  As we've discussed along the way, generative AI might be the most productivity enhancing technological advancement of our lifetime
And high productivity growth is a driver of long-term potential economic growth.  And productivity-driven economic growth comes without the inflationary side effect.
In fact, the annual growth in the cost per unit of output in the third quarter (the most recent report) was negative!  And that came even as the wages paid to produce that unit of output were higher than any time in the two decades prior to the pandemic.  
We'll get the fourth quarter productivity report on February 1st.  But as we've discussed in recent months, although the Fed constantly blamed weak productivity growth as holding back the post-GFC economy, now that productivity is strong, they barely utter the word. 
With that in mind, let's talk about the prepared remarks and Q&A by one of the Fed Governors today at the Brookings Institution.
Chris Waller is a voting member.  His prepared remarks today were clearly written with intent to curb the extent of rate cut expectations priced in the market for 2024.  After the inflation data of last week, by Friday afternoon the market was pricing in seven cuts (175 basis points) by the end of this year.   Remember, the Fed has projected a total of three quarter point cuts for the year. 
The market did indeed, back away from a seventh quarter point cut today (i.e. priced it out).  But Waller did reveal some clues on a more aggressive rate path this year. 
The Fed will get one more big inflation data point before its January 31 meeting.  It's PCE.  And Waller sees it around the Fed's target of 2% (on a 3-month and 6-month annualized basis).
So, target achieved.  But he also says it needs to be a sustained 2%.  He says the Fed can sit back and observe, to ensure it's not a temporary visit at 2%.
Keep in mind, with the effective Fed Funds rate over 5.3%, the real rate (Fed Funds rate – inflation rate) is now over 300 basis points.  The Fed, itself, projects the long-run real rate to be just 50 basis points.  So, the Fed is currently in a highly restrictive stance — putting downward pressure on the economy and on inflation.
That said, with deflationary forces hitting in China, Europe and Canada, I suspect the Fed Chair (Jerome Powell) won't find it too comfortable sitting and watching.  Not only are they already at risk of inducing deflation by being overly tight, but they've created a position of weakness to fight off any economic or financial system shock.  
In the latter case, they would likely find themselves back in the zero interest rate policy/QE business.
I suspect the markets won't let the Fed make that mistake.  Lower stock prices would force the Fed's hand (i.e. force earlier, more aggressive rate cuts).
Now, back to the productivity discussion…
In the Q&A today, Waller actually addressed productivity gains.  As he said wage growth should equal inflation plus productivity gains. And he admitted that productivity is booming, at better than 5%.
5% + 2% = 7%. 
We should have 7% nominal wage growth.  It's running closer to 5%. The Fed should be encouraging wage gains, to close the gap with the rise in the level of prices over the past three years (to restore living standards).  It would be growth enhancing, without stocking inflation.