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This episode has a little bit of everything – continuation of the carry environment as the easing cycle comes into focus, fixed income opportunities related to housing, and investing amidst election uncertainty – even if election outcomes look clearer, market implications can be more challenging to gage.

Following the soft June core CPI reading, markets are discounting about 150 basis points of policy easing over the next twelve months, as reflected in forward overnight index swap rates (chart below). In contrast, at the June meeting the median FOMC participant projected 125 basis points of easing by the end of 2025. While more aggressive than the Fed’s June projections, market pricing strikes me as reasonable. As I wrote last week (and as Powell said during his Congressional testimony a few days ago), the labor market is unlikely to be a source of inflationary pressure going forward. More importantly, as inflation continues to cool, the FOMC will increasingly focus on preventing too-rapid a slowdown in aggregate demand and hiring. This will require getting the policy rate down closer to a more neutral setting sooner rather than later. Lower inflation, even if still moderately above two percent, will afford them this flexibility. Policy adjustments will increasingly resemble Greenspan’s strategy of “opportunistic disinflation,” where going the last mile on returning inflation exactly to target loses its allure if it would come at the cost of too-sharp a slowdown in the economy. Also, we should keep in mind that the “lock-in” effect in the mortgage market is a double-edged sword. Once the Fed turns to easing, the fact that such a modest proportion of households have mortgage rates above 5 percent means that a handful of interest rate cuts will not prompt a refinancing wave, which in prior easing cycles has allowed households to reliquefy balance sheets, supporting consumption.

Having updated my labor market conditions index with inputs from the June employment situation report, it’s clear that the labor market continues to cool gradually. As importantly, I am challenged to see how the labor market will be a source of meaningful inflation pressures going forward. It’s another reason why the Fed should soon pivot to policy easing.

With May core PCE inflation in hand, I updated policy prescriptions from five commonly used monetary policy rules. With an average policy rate prescription of 4.5 percent, most of these rules suggest that a rate cut is now overdue. This reflects the two percentage point decline in the rate of core inflation over the past year, and the very gradual increase in the unemployment rate. Essentially, the conditions that led the FOMC to take the policy rate up to 5.5 percent last year no longer prevail. In this regard, I was struck by Chicago Fed President Goolsbee’s comment this week that, “if you just hold the rates where they are while inflation comes down, you are tightening”.

Quite a day! A very encouraging May CPI print, which led to some market uncertainty about whether and to what extent the data would influence FOMC communications, especially the new Summary of Economic Projections. At the end of the day, the Committee took a cautious approach, and is not over-reacting to one data point. The median Committee participant now projects just one rate cut this year, against a backdrop of still-elevated inflation at year-end, along with solid growth and a healthy labor market. Although the median Committee participant sees just one rate cut this year, eight participant project two. This suggests that support could grow over the coming months for a September rate cut, but that would really take consistently moderate inflation prints between now and then. Big picture: after Q1’s firm inflation prints, along with indications that some policy makers might not view the policy stance as overly restrictive, it will take some time for the Committee to regain confidence that inflation is on a sustainable path to two percent. Please see video below for my full analysis:

Amid uncertain future yields, three scenarios emerge. In this video, we outline potential 3-month Treasury yield paths. Learn more → https://lnkd.in/eFiu_w5n