The Waller effect

Chris Waller expressed confidence on Tuesday that the current policy is well-positioned to slow the economy and bring inflation back to 2%. His remarks, made during a speech at the American Enterprise Institute, were seen by the market as confirmation that the Federal Reserve is done raising interest rates, which aligns with the market sentiment as additional hikes had already been largely priced out earlier in the month.

Although he didn't completely rule out raising rates again (the Fed has to retain the pretense of two-way policy risk), Waller described himself as "encouraged" by the incoming data. "Something appears to be giving," he said. "It's the pace of the economy."

Like his old boss, Jim Bullard, Waller is a born-again hawk — an erstwhile dove who changed his feathers during the post-pandemic inflation fight. If he's satisfied that terminal is achieved, it's a solid nod to the idea that the bar is quite high for another rate increase.

While some observers noted divergent remarks from Michelle Bowman, her comments are not as closely scrutinized. Though nominally important, Bowman doesn't carry the same weight as a bellwether. Moreover, her remarks on Tuesday included a caveat: "I remain willing to support raising the federal funds rate at a future meeting should the incoming data indicate that progress on inflation has stalled." This conditional stance is seen as conciliatory and suggests she may be under mild pressure not to appear entirely out of step.

Crucially, Waller hinted at insurance cuts in 2024, not as a measure to save the economy or avert a recession, but rather to prevent the Fed from tightening passively through the real policy rate channel as inflation recedes. He stated, "If we see disinflation continuing for several more months… you could then start lowering the policy rate just because inflation's lower."

In the context of insurance cuts and the December Summary of Economic Projections (SEP), it's noteworthy that if the Fed doesn't hike next month and the median 2024 dot doesn't shift, they'll eliminate a rate cut. The September dot plot indicated 50 basis points of cuts next year, but from a higher terminal rate that now appears unlikely to be achieved. So, suppose the 2024 dot doesn't move lower. In that case, Jerome Powell must reconcile the idea of just one rate cut in 2024 against market expectations for around four, and more importantly, against expectations for significantly lower core inflation.

If core inflation continues to fall, it'll be challenging for the Fed to square the circle between consistent messaging from officials (like Waller on Tuesday) about cutting to prevent the real policy rate from rising mechanically and telegraphing just one 25bps cut for the entire year. There's too much cognitive dissonance there, and the market won't bear it, particularly if Fedspeakers explicitly nod to insurance cuts in public remarks.

Contrary to the musings of a terminal blogger or two on Tuesday, I see no reason for the market to pare back expectations for 100bps of cuts in 2024. Two insurance cuts to keep up with falling inflation gets you halfway there already, and that doesn't count any cuts aimed at short-circuiting nascent risks to the labour market or any type of insurance the Fed might take out in the event of exogenous shocks.

Of course, the problem is that no matter how rational expectations for rate cuts in 2024 might be (or at least might sound), those expectations can feed irrational overshoots in asset prices in the meantime, which is where the financial conditions reflexivity comes in.

Coming full circle, Waller did at least acknowledge the financial conditions feedback loop. However, it's pretty clear the Fed thinks the disinflation process is entrenched in the real economy such that any rekindled wealth effect from financial asset appreciation likely won't derail things.

"The recent loosening of financial conditions is a reminder that many factors can affect these conditions and that policymakers must be careful about relying on such tightening to do our job," Waller said.