2024.04.03 09:25
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Bank of America: Fed "internal strife", Powell, Waller differ, the risk is "if it can't be lowered in June, then we have to wait until March next year"

Bank of America is more supportive of Powell's view, that is, to keep the possibility of a rate cut in June rather than preemptively judging the data, in order to avoid unnecessary financial market tightening risks

Internal divisions within the Federal Reserve over policy direction are intensifying, especially between key figures Powell and Waller.

Last week, Federal Reserve Chair Powell and Governor Waller made significant speeches on the outlook for interest rates. The former continued to show a dovish attitude, stating that if economic activity continues to weaken, the Fed will cut rates. The latter, on the other hand, displayed a more hawkish stance, describing recent inflation data as "disappointing" and suggesting that there is no need to cut rates within the year.

In response, Bank of America's analyst team led by Aditya Bhave released a research report on Tuesday local time, stating that due to the base effect of year-on-year core PCE inflation, the situation remains favorable until May, but 6 out of the 7 months at the end of the year are unfavorable. If the Fed cannot provide sufficient reasons for a rate cut in June, they may have to wait until March 2025 to start cutting rates.

With inflation rates still relatively low, Bank of America supports Powell's view of retaining the possibility of a rate cut in June, rather than making premature judgments based on data, in order to avoid unnecessary financial market tightening risks.

Powell Continues to Show a Dovish Stance

Bank of America believes that Powell's remarks last Friday were overall balanced, but his overall stance still leans towards dovishness. The current key issue is determining the timing of a rate cut rather than the possibility of a rate hike.

Powell's policy response shows a clear asymmetry: if economic activity weakens, the Fed will consider cutting rates, but if economic activity remains strong and inflation does not rise, the Fed will not shift to a more hawkish stance.

Implicitly, we believe Powell's basic assumption is that future economic growth will be entirely driven by supply rather than demand. Data needs to prove that demand is accelerating. This is consistent with Powell's emphasis on the expansion of labor supply.

It is worth noting that although Powell stated that the Fed is not in a hurry to cut rates, he mentioned that February core PCE inflation "basically meets our expectations," implying his optimistic view on the inflation reduction process.

In other words, the downward trend in inflation has not been disrupted.

Finally, Powell also discussed the divisions within the FOMC during Friday's event. Powell stated that the divisions are "not a problem" and that "life goes on."

In response, Bank of America wrote:

These comments are interesting, as we are starting to see widening cracks within the committee. We believe this is a natural phenomenon as policy disagreements often intensify as decision points approach

Waller's Hawkish Stance

Waller displayed a more hawkish attitude in his speech last Wednesday, stating that there is no need to cut interest rates this year. He believes that the risks of delaying rate cuts are much lower than cutting rates prematurely. Unlike Powell and Brainard, Waller believes that the current policy risks are not balanced.

Bank of America pointed out that Waller pays less attention to supply-side factors, and he did not even mention the impact of immigration and increased labor force participation on labor supply, which has been a focal point of Powell's discussions.

Waller's concerns about strong consumption exceed Powell's, possibly because he views inflation as being driven by demand rather than supply.

After Waller's speech, industry insiders analyzed it from different perspectives. Some interpreted that Waller believes the current financial environment is still tense.

Waller stated that he will closely monitor the loose conditions of the financial conditions index, mainly driven by the stock market—especially the Mag 7. He also pointed out that the tightening of credit spreads may be due to increased private lending.

He believes that the current financial environment is tense because real interest rates are still high. (Previously, Powell's remarks at the press conference were interpreted by the market as the financial environment may further ease)

Three Major Reasons for the Fed's Internal Disagreements Intensifying

Bank of America believes that the main reasons for the disagreements between Powell and Waller are as follows:

First, there is a difference of opinion on whether the strong economic momentum comes from the supply side (with deflationary effects) or the demand side (which may lead to inflation). In last week's speeches, Powell focused on the supply side, while Waller focused on the demand side.

It is worth noting that supply-side issues took center stage at the Federal Open Market Committee (FOMC) meeting in March, as can be seen from the economic forecast summary:

Growth expectations for the next three years have been significantly raised, but inflation and policy rates have only moderately increased, and the unemployment rate has hardly changed.

Second, there is a disagreement on how to balance the Fed's dual mandate (ensuring a soft landing while returning to the 2% inflation target).

Some policymakers may be willing to accept a longer path back to 2% inflation to ensure a soft landing. Others may prioritize restoring inflation to target, even if it means a greater slowdown in activity.

Third, some policymakers are more concerned about the "jump risk" in the policy path.

Bank of America pointed out that due to the base effects of core PCE inflation on a year-over-year basis, the favorable effects will last until May, but there are 6 unfavorable months out of the 7 months at the end of the year. **If the Fed cannot provide sufficient reasons for rate cuts in June, it may have to wait until March 2025 to start cutting rates From May to August, the base effect averaged over 0.3% per month, while from June to December, the base effect averaged below 0.2% per month.

For overall PCE inflation, the average monthly base effect for the three months ending in May was 0.18%. This number is expected to be 0.17% per month in the second half of 2024.

For the Federal Reserve, the current annual growth rate of overall PCE inflation is relatively low at 2.5%, while the core inflation rate is 2.8%. This is a positive sign as inflation rates remain at relatively low levels.

Will the Fed start cutting rates in June?

Does this jump in risk mean that the Fed should start cutting rates in June?

One view is that the Fed should "strike while the iron is hot" and begin easing rates. Even with three rate cuts this year, rates would still be seen as restrictive by most estimates.

Not cutting rates this year could risk significant financial tightening, with the 10-year yield possibly returning to 5%, intensifying concerns for regional banks, commercial real estate, and high-yield credit.

Another view is that when financial markets lowered expectations for rate cuts earlier, the financial environment did not actually tighten.

Currently, Bank of America believes Powell is more inclined towards the first camp rather than the second.

Our view is that he has the ability to persuade most Federal Reserve members to support his views. Reflecting on his comments about internal committee disagreements, he seems comfortable with policy decisions that are not unanimously agreed upon. Given Powell's moderate stance, this increases the likelihood of a rate cut in June.

What does this mean for policy predictions? Bank of America points out:

From a year-on-year perspective, demand-driven inflation remains relatively stable, while supply-side drivers have improved significantly. This is consistent with Powell's views.

However, looking at the base effect over 6 months, demand-driven inflation has accelerated in recent months, which aligns more with Waller's concerns, although the calculation of the 6-month growth rate may be influenced by seasonal factors.

Taking everything into account, Bank of America maintains its forecast of three rate cuts this year, with expectations for rate cuts to begin in June. However, if there is an increase of 30 basis points or more in the next two core PCE data releases, especially if economic activity remains strong, the likelihood of a rate cut in June may decrease