US Strategy Weekly: To Cut or Not to Cut

The Federal Reserve is likely to lower interest rates by 25 basis points this week, but we doubt the Federal Open Market Committee will be unanimous in its decision and for good reason. In our view, at this juncture there is no need to lower interest rates and in fact, another rate cut could risk encouraging a rebound in inflation. But unfortunately, the Federal Reserve Board Chaired by Jerome Powell has never disappointed the consensus in the past, and we doubt this pattern will change this week. This predictability of the Fed is unfortunate because an obvious and dovish Federal Reserve emboldens speculation which is the opposite of what a central banker should do. In our view, Wednesday’s compromise will be that the Fed lowers interest rates by 25 basis points but makes a hawkish statement indicating that additional cuts may, or may not, be needed, in 2025. At least this will keep the consensus guessing in the near term, which is good.

Positives

There is a slew of indicators that suggest the economy is in good shape and may actually be accelerating as 2024 ends. The University of Michigan and Conference Board consumer sentiment surveys have both shown a significant boost in confidence in recent months. The NFIB small business survey jumped to its highest level since June 2021 in November. Consumer credit expanded by $19.2 billion in October and despite an increase in inflation, real personal disposable income grew a healthy 2.6% YOY in the third quarter. The National Association of Home Builders survey improved substantially in November and expected sales of single-family homes over the next six months jumped to 64, its highest level since April 2022. The pending home sales index rose 5.2 points in October to 75.8. Top-line retail sales were far better than expected in November, marking the third straight month of strong growth. This was the first time sales have grown strongly for three consecutive months in over a year.

Negatives

There are some areas of concern. Industrial production fell 0.1% in November following a downwardly revised 0.4% decline in October (previously -0.3%), leaving output 0.9% lower than a year earlier. This was the weakest annual rate since January. More importantly, despite the fact that the November jobs report showed an increase of 227,000 new jobs in the month, the household survey told a different story. It indicated there was a decrease of 355,000 jobs in the month and an increase of 161,000 people unemployed, and this is what led to the increase in the unemployment rate from 4.1% to 4.2%. However, the household survey also shows that the number of people employed declined by 0.45% YOY in November. This was the second contraction in four consecutive months, and it is significant because a steadily declining labor force is a classic sign of a recession. This could explain the Fed’s desire to lower interest rates.

Inflation Dilemma

Still, the Fed’s big dilemma in 2025 could be a resurgence in inflation. Headline inflation accelerated for the second month in a row in November, rising 2.75% (which the BLS rounded to 2.7%) year-over-year versus 2.6% in October. Core CPI rose 3.3% YOY, unchanged from a month earlier. Note that headline CPI speeded up even though the energy component fell 1.7% for the month and 3.2% YOY. Also notice that all major segments of the CPI rose more than the headline number except for transportation, and lesser components such as education and communication, recreation, and apparel. See page 3.

On a positive note, both headline and core CPI have been below the 77-year long-term average of 3.7% YOY for many months; but unfortunately, prices have now become sticky, and several areas of the economy — such as airline fares — are experiencing price acceleration. In particular, one of the Fed’s favorite benchmarks — all items less shelter — rose 1.6% YOY up from 1.3% in October and is up from 1.1% in September. Most economists are encouraged that shelter inflation was 4.7% YOY in November, down from 4.9% in October and owners’ equivalent rent was 4.9% YOY in November, down from 5.2% in October. Nevertheless, while shelter inflation may be decelerating (some of this due to falling energy costs), it remains elevated. See page 4.

Energy costs were the initial driver of inflation; however, service sector inflation is the current problem, and the broad service sector saw prices rising 4.5% YOY in November, down a bit from 4.7% in October. Conversely, medical care costs which averaged 0.2% YOY gains in 2023, rose by 3.1% YOY in November and have been rising 3% YOY or more for the last seven months. The only consolation to the sharp rise in medical care costs is that price spikes seem to appear every four years and should be peaking in 2024. See page 5.

Wages grew 3.9% YOY in November versus the CPI’s 2.7% YOY pace and have been growing faster than inflation since May 2023. This is a potential problem since it means that inflation may be making a classic shift from being supply-driven to demand-driven. We believe the Fed sees this risk but is either ignoring it or is more concerned about a weakening labor market. With inflation at 2.7%, assuming the Fed announces a 25-basis point cut this week, the real fed funds rate would fall from the peak of 280 basis points seen in August to 160 basis points this week. This 160 basis points would still be above the long-term real fed funds rate average of 130 basis points but is a dovish move and we think the timing would be poor. See page 6.

Price Action

The Dow Jones Industrial Average closed down 267 points on Tuesday, for its ninth-straight day. According to FactSet, this index has not had nine consecutive down days since February 1978, so this decline is gaining attention. However, we would point out that the other indices have not had the same trend, and this Blue Chip index has several unique factors that explain its weakness. First, Nvidia Corp. (NVDA – $130.39) replaced Intel Corp. (INTC – $20.44) in the DOW 30 on November 8, 2024, and the stock peaked at a price of $148.88 on November 7, 2024. The subsequent sell-off in NVDA is a phenomenon that often happens to new stocks added to an index due to pre-buying. In addition, United Healthcare Group Inc. (UNH – $485.52) has been in a tailspin since the murder of UnitedHealth CEO Brian Thompson on December 4, 2024. This horrible event has become a flashpoint for the healthcare industry and a group of lawmakers are pushing to force health insurers to sell pharmacies. Our technical indicators remain positive, but there have been signs of deterioration in the past week. The 10-day average of new highs is now over 100, turning the new high/new low index from positive to neutral. It is also mid-December, and strong cross currents always occur at year end. We believe the stock market will move higher but fear it may peak around Inauguration Day since a lot of good news has already been factored into prices. In addition, the S&P 500 index is currently trading at 25.9 times trailing earnings. Historically, only stock market bubbles have reached 30 times earnings. See page 8.

Gail Dudack

Click to Download