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Waiting for Godot

It Was a Long Wait, But the Fed Recognizes Rates Have Peaked

Exit, pursued by a bear

Samuel Beckett's absurdist tragicomedy Waiting for Godot famously features two characters, Vladimir and Estragon, waiting for the arrival of the titular character, Godot. The play preoccupies itself with what goes on while they wait, and it is these diversions from their purported intent that comprise its sole drama, particularly because Godot does not in the end arrive. The final stage direction of the play: They do not move.

The market's anticipation of the December's meeting of the Federal Reserve's Federal Open Market Committee (FOMC), its interest rate policy-setting body, was remarkable for its similarity. The FOMC voted to leave the overnight interest rate unchanged at 5.25% - 5.5%, as was expected by the market. Surprises are uncommon, as the Federal Reserve generally doesn't like to ambush the markets, as this would contribute to volatility, and everyone knows that no one likes volatilty except volatility traders.

Prior to the meeting, we received two important datapoints that confirmed the Fed in its rate policy. First, the Consumer Price Index (CPI) for all Urban Consumers came in flat at 3.1%. No change in the general price level is good news, since it means that the Fed is satisfying the first of its three mandates, to ensure price stability. While core inflation remained higher at 4.0%, the downward trend in inflation continues making the Fed's job easier and the end consumer feeling less beleaguered.

The CPI, like all samples, contains flaws that make it an imperfect representation of the whole. One way in which the CPI fails to be representative is the inclusion of Owner's Equivalent Rent in its index. This measure attempts to capture the cost of shelter, which is a huge component of CPI at between 30%-40% of the index. However, the imputed rents that this inclusion represents are not actually paid by homeowners to themselves, and so do not necessarily represent arms-length transactions. While the price of homeownership has remained high due to higher interest rates, the price consumers pay to rent has been falling, creating downward pressure on the CPI. This is captured in the Harmonized Index of Consumer Prices produced by Eurostat to make US CPI comparable to European CPI. It shows that inflation has nearly arrived at the Fed's 2% target level, a development which we are sure is celebrated with some regularity inside the halls of America's central bank.

Similarly, the Producer Price Index, a measure of inflation in the pipeline, is also descending and shows that the supply chain stresses that contributed to inflation continue to ease. Capacity Utilization is also down, showing that the economy is backing off the inflationary levels at whcih it had been running. While these measures are showing moderation in economic activity, they don't show these measures crashing either. The economy is running at a rate that is consistent with ordinary growth and not inflationary.

Our gauge of economic activity suggests real growth in the 2.5% neighborhood--still higher than trend over the past decade, but certainly in line with potential GDP. These levels of growth are not inflationary, and in fact should continue to contribute to falling inflation.

The Federal Reserve also updated its forecasts of interest rates for the next several years, betraying a belief that rates will remain generally where they are, and perhaps fall .75% over the course of 2024. The interest-rate sensitive short-end of the interest rate curve fell in response as the market updated its expectations from four or five interest rate cuts in 2024 to just three. This would suggest that the Fed believes that rates will have to fall in 2024 to avoid depressing economic growth as inflation continues its descent, and that inflation will likely be at its target rate by the end of the year.

Orange is the curve as of the day prior to the FOMC meeting, and blue as of the EOD of the FOMC

Lower interest rates are good for all assets that depend upon future cash flows for their value, since the opportunity cost of investing in the future is lower and the cost of consuming today is higher, and lower costs are good. Nearly all assets rallied on the Fed's recognition that we're past the point where it is at all likely to raise rates again in the forseeable future. This fact is enjoyed by none more than money managers, as their compensation structures are typically built around annual performance, and a year-end assessment.

Unfortunately for the Fed, which did everything it could to prevent the market from joyously celebrating the arrival of the end of the tightening cycle with higher asset prices and lower discount rates, the lowering of these costs create exactly the type of environment that it didn't want to create: one where financial conditions are relaxed, and therefore more likely to spur on inflationary levels of growth. While the wait for the peak has arrived, we wonder if the Fed won't leave rates where they are just to prevent economic conditions from getting out of hand and reigniting inflation. Whatever will be will be, but with no clear signs of economic weakness currently visible, the Fed looks set to take its Goldilocks economy to the New Years Eve party.

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