September 2024: Keeping score: There were three “invisible” gorillas at the Sept FOMC.  What does it mean for US banks?

An “invisible” gorilla describes the problem of selective attention/blindness in human cognition. Basically, if we are told to focus on something (count the number of times people in white shirts pass the ball to each other on the basketball court) do we fail perceive other unexpected things (like a gorilla running through)?

Moorad now owes me coffee and cream cakes/pastries on my next visit — which is all in good fun, of course (I will confess that I had to confirm with him what “cream cakes” are!).

So there were three “invisible” gorillas at the September FOMC — what were they?

First, there were no questions at the FOMC press conference about the wisdom of US policymakers embarking on a contemporaneous easing in monetary and fiscal policy.   

Effectively, that is what happened this week.

• The most recent data from August on the US fiscal position shows a significant widening in the US budget deficit to GDP largely due to spending increases even as the Fed has begun to aggressively cut rates. Just because the Fed does not opine on fiscal policy doesn’t negate the importance of the US fiscal policy stance. The press conference and market’s lack of focus on the interaction between fiscal and monetary easing was by far the most striking “invisible” gorilla of the September FOMC meeting.

• So, the US economy is receiving both types of stimulus simultaneously — a situation that prevailed in the 1970s when the Fed made a significant monetary policy error and inflation resurged.

• Both the dominance of and recurring underestimation of the importance of fiscal policy remains a crucial theme. After the 2024 election, it is plausible to expect a further widening of the budget deficit.

Second, a (relatively) data (in)dependent FOMC.

• The vast majority of macroeconomists did not forecast a 50 bps rate cut and instead looked for 25 bps — why?

• Simply put, US aggregate economic data had shown no evidence of worsening since the July FOMC meeting. For example, the Atlanta Fed’s GDPNow rose into the September FOMC meeting.

• The US unemployment rate was little changed since the July FOMC meeting. History suggest that a significant worsening in the US labor market with a budget deficit of this magnitude is unlikely absent a major financial shock like occurred in 2008. The chart below shows the US unemployment rate on the vertical scale and the US government budget deficit to GDP on the horizontal scale.

Corporate credit spreads are super tight for a 50 bps rate cut and not flashing red. Corporate credit spreads are a relevant metric for the labor market outlook. Corporates are not in distress and relatively less likely to shed workers.

• Rather, what changed last week was sentiment in light of a series of news articles (WSJ, FT) quoting former FOMC members who largely argued for a 50 bps cut based on the argument that policy is becoming more restrictive with inflation coming down. [Note that this framing of the problem misses the invisible gorilla and seems to assume no change in the US fiscal policy stance]. In aggregate, the US economy has weathered higher for longer interest rates surprisingly well.
• While higher interest rates have increased wealth inequality and put stress on certain sectors of the economy, the problems of banks, CRE, low income consumers cannot be solved through monetary policy. A tightening of the US fiscal policy stance would better support the Fed lowering interest rates.

Third, long-dated Treasury yields rose post FOMC as the probability of a Fed policy error on inflation has increased.

• The rise in the 10-year nominal Treasury yield (and 30-year mortgage) after the FOMC announcement has garnered market attention, though some market observers have offered relatively benign explanations for it.

• Some observed that long-dated Treasury yields rose because the FOMC meeting demonstrated/clarified that the US economy is strong. This explanation does not seem highly plausible as the US economy’s strength was easily observable ahead of the FOMC and was not new news.
• Others have observed that the Fed’s dot plot suggested that there was not a strong consensus to cut interest rates significantly further with nine FOMC members not sold on big further rate cuts this year — described by some as a hawkish Fed cut. This explanation for higher long-dated Treasury yields does not square well with the futures implied pricing of the Fed’s policy path which priced in more easing after the September FOMC meeting.

It also does not square with some market commentary after the meeting suggesting that (rightly or wrongly) participants expect more hawkish FOMC members eventually will get cajoled into further rate cuts in Q4. Stated differently, their view is that the path implied by the dot plot is not to be taken seriously given the large revisions to the Summary of Economic Projection (SEP) from June to September.

• A more plausible explanation is that the market has begun to price in a risk premium associated with a Fed inflation policy error in light of Committee’s large September rate cut and strength of the US economy.

In sum, the risks of a Fed policy error on inflation in late 2024/early 2025 rose this week. As central banks are more akin to oil tankers than speedboats, policy missteps can persist and compound so it is important to be on watch. It also is plausible that changes such as aging US demographics, greater capital intensity and changing geopolitics/reshoring imply higher investment and lower savings permanently raise the neutral long-run interest rate relative to pre-pandemic levels. From this vantage point, the FOMC’s forecasts in the September SEP for the long-run rate look low.

What does the September FOMC mean for US banks?

Risks of an inflation/Fed policy error and a higher neutral rate than pre-pandemic both imply that it is important for banks (and other actors in the economy) to not bet the farm that US interest rates will decline sharply. ALM models that suggest loading up on lots of long duration securities to support profitability — and improving profitability is a key area of concern — should be reviewed very carefully. Also, for banks an accelerating US economy and declining interest rates suggests some likely improvement in loan demand. At the same time, ongoing QT into early 2025 remains a liquidity drain for the US banking sector and potential strains in funding markets are a concern.