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The US economy began 2024 where it (mostly) left off 2023 — surprisingly strong.
In turn, investor expectations for interest rate cuts from the Federal Reserve have been pushed out into the future. But a strong economy is an asset, rather than a risk, to the Fed’s plans.
In its forecasts released in December, Fed officials saw real GDP growth in 2024 coming in at 1.4%. Over the long run, officials see the economy growing at rate of 1.8%. So not only were these forecasts calling for the rate of growth in 2024 to be sharply lower than the 2.5% increase seen last year, but for this year’s economy to come in below potential.
Wall Street forecasters are similarly cautious.
As of Monday, the Atlanta Fed’s GDPNow forecast showed the US economy is set to grow at an annualized rate of 2.9% in the first three months of 2024; Wall Street forecasts peg growth closer to a rate of 1.8%.
In a note to clients on Monday, Neil Dutta at Renaissance Macro wrote that “consensus is beginning to come around to a stronger growth view,” as these “Blue Chip” forecasts have been consistently on the rise since December.
Still, Dutta argued that it is time for Street consensus to “wake up” when it comes to the growth outlook.
“According to the latest Blue Chip Quarterly Consensus Forecast, real GDP is expected to climb no more than 2.1% at an annual rate in any quarter between now and Q4 2025,” Dutta wrote. “Moreover, a slowing in growth is expected between Q1 and Q2 2024.”
“I am sorry, but these forecasts do not make any sense to me,” Dutta added.
In Dutta’s view, expectations around consumption are too conservative. Moreover, recent survey data, along with higher stock prices, makes an increase in business investment likely.
All while inflation expectations suggest strong inflation figures posted earlier this month — and expected later this week — don’t change “the overarching story on inflation.”
“Underlying inflation is slowing, and this puts the Fed on a path to recalibrate monetary policy,” Dutta wrote.
As Josh Schafer reported last week, consensus forecasts now have the Fed cutting rates three times in 2024, down from six expected cuts when the year began. In December, the Fed’s own forecasts suggested three cuts would be warranted this year.
Investors, by and large, remain focused on rate cuts. And for good reason — all else equal, nothing matters more for valuations than interest rates.
But the story underwriting these revised views on rate cuts is much simpler than calculating the discounted value of a company’s future cash flows or doing a close reading of the latest round of commentary from Fed officials.
The story is simply about growth.
‘The bulk of the negative shock has passed’
Elsewhere in his note, Dutta also raises a more heady observation about the nature of how monetary policy functions in the modern marketplace.
One of the most popular descriptions of monetary policy is that it works on a long and variable lag.
Paraphrasing the work of economist Milton Friedman, this idea captures the uncertainty with which the Federal Reserve and other central banks operate along the axes of both time and magnitude.
The question of high or low interest rates should be set, and for how long they should remain at any one level, is answered slowly and piecemeal.
As Fed Chair Jerome Powell said in his first Jackson Hole speech after taking the top job, navigating policy by the “stars” of natural unemployment, the neutral rate of interest, and the Fed’s inflation target “… can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly.”
And there is no doubt that changes in the economy since the pandemic began four years ago have been significant. But the scope and scale of these shifts, however, have begun to call into question this central idea of how monetary policy works its way through the system.
“The consensus appears to continue believing that lags from prior monetary tightening are non-linear in nature,” Dutta wrote. “The consensus is marking to market the near-term view, only to push the slowdown off by another quarter.”
In other words, a long and variable lag for policy means any negative impacts not yet experienced have been delayed, rather than averted.
“Under this theory,” Dutta continued, “higher rates have minimal effects up front, the economy performs well, and then suddenly, the economy spontaneously combusts. I’m skeptical.”
“The lags are shorter today; after all, the Fed first broke the housing market without lifting the federal funds rate. Financial market conditions tell a simple tale as well: the bulk of the negative shock has passed.”
One of the most enduring debates in markets is whether the stock market is the economy. In other words, does a rising stock market mean the underlying economic fundamentals are improving?
On balance, I tend to come down on the side of yes.
And the market’s behavior over the last 15 months is a case in point.
Entering 2023, a recession in the US economy was preordained by most on Wall Street. Instead, economic growth accelerated and the S&P 500 rose 24%.
In 2022, in contrast, the S&P 500 fell nearly 20%. And, as Dutta noted, the housing market was “broken” by the Fed as it aggressively raised interest rates. All while consumers grappled with 40-year highs in inflation.
Though headline economic data in 2022, bolstered by nonresidential investment and a strong dollar, didn’t reveal a recession defined by consecutive quarters of headline GDP contracting, most consumers felt many of the hallmarks of an economic downturn.
And while there are pockets of weakness in the economic backdrop right now — white collar employment trends come to mind — financial markets appear firm in their assessment.
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