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Tuesday, March 26, 2024

Late Central Bank Comments

Since I am still chugging away with edits, I have not been spending much time watching developments in markets. I just wanted to off some brief comments on events from central banks last week. I have a longer manuscript section for publication later this week.

The Bank of Japan threw in the towel on negative interest rates last week. Yay, yen interest rates will go back to their low positive “normal.” This change is not that significant, other than on a psychological basis. I have not been following Japanese data closely, but my tendency is to expect glacial changes in economic conditions.

The Federal Reserve released the projections of the FOMC members. I have never been a big fan of spending too much time dissecting those projections — the main issue for markets is determining when the FOMC is completely out to lunch. However, they have deepened their expected rate cuts over this and the following years (the projections are for December year end).

Although I think a couple cuts to the psychological level of 5% is fairly plausible, I am unsure about the sustainability of slow-paced rate cuts. During an expansion, the usual tendency is for growth and inflation to bump up and down around their “steady state” levels (which may be only obvious in retrospect). There will be periodic “growth/inflation scares” that suggest that the economy might accelerate.

Meanwhile, the loons in the risk markets will over-extrapolate any rate cuts. There will be screaming about the Fed (or the FED!) inflating asset bubbles if risk assets do what they do most of the time (go up). American policymakers spend way too much time obsessing about equity markets. (Greenspan was seen as a major culprit behind this tendency, but I do not spend a whole lot of time worrying about much earlier eras of policymaking.) It will be very easy to say “Mission Accomplished” after a few token cuts if the bubble narrative takes off again.

Things are different if the real economy starts to convincingly roll over. However, it is hard to sustain baby step rate cuts in such an environment.

As such, I would not take the rate cut path in the markets too literally. Instead, one can come up with plausible stories for divergences in either direction from the path of forwards. This is the mirror of the case of gradual rate hikes being priced into the curve when the central bank is widely expected to remain on hold.

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(c) Brian Romanchuk 2024

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