Reiterate 3 Rate Cut Forecast

We are reiterating our forecast of 3 Fed rate cuts over the next year despite the hawkish press conference by Warsh and a dot plot that indicates 2 rate hikes this year.  In fact, we interpreted Warsh’s press conference as very bullish due to the potential for reforming the Fed.  Specifically, Warsh softened up the arbitrary 2% target by focusing on the “left side of the decimal” target of 2.0%. This implies the Fed’s de facto absolute ceiling for inflation is 2.9%.  This is a critical update to policy as during the 2000’s the Fed treated the 2.0% target as a hard ceiling resulting in 17 rate increases in a row despite inflation never significantly exceeding 2.0%. This ultra hawkish policy resulted in the money supply growth being flat for 3 years and precipitated the Great Financial Crisis.

In addition, Warsh formed a task force to reform the data flow the Fed relies on by modernizing data collection to make it market based and real time.  This reform effort recognizes the fact that the shelter component of inflation is delayed 2 years.  If the Fed improves the calculation, the new index will result in PCE Core immediately declining to a level below the Fed’s arbitrary 2% target (see our real time inflation indices at infracapfunds.com). In addition, the task force activity is likely to reform the Fed’s deeply flawed forecasting models to include the money supply as the key driver of inflation.   This would give the Fed impetus to cut as money supply growth is currently negative implying we are headed toward deflation.

Finally, the communication task force is likely to eliminate the notoriously inaccurate dot plot forecast.  The most recent dot plot is a stark example of how bad the current members of the Fed are at forecasting. The Fed members failed to recognize the recent 25% plunge in oil prices which will certainly result in negative headline inflation reports over the next two months and cause core CPI and PCE to decelerate dramatically as the energy price decline bleeds through to core. Consequently, the probability of a Fed increase in the face of plunging inflation is zero.

We believe that the formation of the task forces was meant to lay the groundwork for rate cuts, since Warsh cannot force rate cuts as there are only 3 Republican supply-side/monetarists on the FOMC.  Consequently, Warsh needs to build a new policy framework to convince the full FOMC to cut rates down to the neutral rate of 2.75%. Fortunately, the decline in energy prices, the rolling off of tariffs, and the gradual decline in the 2-year delayed shelter component of CPI will cause PCE core to decline to below 2% over the next year even if the Fed reforms are delayed. 

As the likely 3 cuts are priced into Fed Fund futures, the 10-year bond will decline to below 4% as it normally trades 100bp over the terminal Fed Funds rate. This decline will support our 9,000 target on the S&P 500 index as every 25bp drop indicates a one point increase in the theoretical multiple on the S&P. A 10-year treasury is consistent with a 23x multiple on the S&P which is implicit in our 9,000 target.