Chart of the Week

THE FED’S U-TURN

Whilst the Central Banks really pivoted in late 2022 (when they began providing many commercial banks and other parts of the financial system with liquidity support) they have only in recent weeks explicitly signalled the end of their rate hike cycles.

This is big news for markets, given how important financial conditions are in setting the tone for equities and most other asset classes.

At its December meeting, the Federal Reserve surprised investors by not only suggesting the rate hike cycle is over, but also forecasting a series of rate cuts in 2024. That’s a significant U-turn for policymakers who have spent two years arguing their sole focus is on quashing inflation.

Which begs the question, do they know something about the economy that the rest of us don’t?

The chart below helps to explain the Fed’s evolving stance. It shows how headline CPI inflation has been trending on an annualised basis over a 3 month rolling period. This measure excludes shelter CPI and is often preferred by the Fed (and market participants) because of the lagged nature of housing and rental costs in the official CPI statistics. For instance, whilst shelter CPI has been a big driver of higher inflation over the past 12 months, we know it will continue to ease sharply over the coming months.

As of November, CPI ex-shelter was contracting by 2.5% on a 3 month annualised basis, suggesting the US economy has recently entered into a period of mild deflation. This is what’s likely worrying the Fed. It may well prove to be a relatively short-lived trend within a broader, multi-year inflationary regime but, for now, it means lower bond yields and a generally constructive outlook for markets.