Should the Federal Reserve cut policy rates in March? If you look at the so-called Taylor rule — named after the legendary American economist John B Taylor — the answer is a definite “yes”.
After all, this formula — which projects the optimal rate using variables such as price levels, unemployment and real income — currently implies that “the fed funds rate today should not be 5.5 per cent but 4.5 per cent”, as Torsten Sløk, chief economist at Apollo, notes.
That is a big gap. No wonder markets have moved in a way that implies there will be half a dozen US rate cuts this year, with a 70 per cent probability that this starts in March.
But if you listened to the chatter that emanated from the World Economic Forum last week, the answer would be very different. “It’s too early to declare victory [over inflation],” François Villeroy de Galhau, the governor of France’s central bank, told participants in Davos. “The job is not yet done.”
Or as Philipp Hildebrand, former head of the Swiss central bank and now at BlackRock, echoed: “At some point we’re going to realise that it’s not that easy to stabilise to the 2 per cent inflation targets that central banks are looking for, and so the optimism in rates in the US in particular is probably overdone.”
One could deduce from such statements that some think the Taylor rule is wrong, and/or best ignored. Does this matter? A cynic might say not. Central bankers always dislike the idea of being front-run by markets, and many economists consider the once-hallowed rule to be excessively crude.
But to my mind this dissonance points to a much bigger question that investors need to ponder: will political factors dominate economic fundamentals in 2024, or vice versa? Or, to put this in monetary policy terms: will inflation be shaped primarily by demand cycles and economic fundamentals this year? Or will supply-side issues, often linked to politics, rule?
Until recently, the working assumption for most central banks and economists was that demand cycles mattered most. Hence the widespread use of neat models — like the Taylor rule — that forecast the future by using past data about economic fundamentals.
But Covid overturned this sunny confidence, since inflation surged due to supply chain shocks in 2021, then tumbled in 2023 when the shocks eased. To be fair, demand mattered too: as recent blogs from the White House Council of Economic Advisers note, a Covid fiscal stimulus boosted demand in a way that contributed to price growth. Last year’s rate rises did the reverse.
However, the CEA calculates, using research by Janet Yellen before she became Treasury secretary, that 80 per cent of recent disinflation was due to supply swings. Which, of course, lie outside the Fed’s control — and its models.
This is humbling for central bankers. So, too, for business leaders. Back in January 2023, for example, I asked a group of top executives to predict US inflation trends. Most forecast a figure above 6 per cent in 2024, way above the current 3.4 per cent.
The good news is that some economists are trying to change their models in response. Elisa Rubbo of Chicago Booth, for example, has developed a “Divine Coincidence index” that tracks supply shocks alongside demand swings in inflation forecasts.
The bad news, however, is that this work is in its infancy and has not been officially incorporated into central bank models. Hence the key question: how will these supply and demand patterns play out in 2024, in the US and elsewhere?
If you are an optimist focused on economic fundamentals — as many in Davos were — you will assume that demand cycles rule. After all, the Covid lockdowns have ended and companies are now more adept at managing supply chain shocks, be they a loss of Russian gas or shipping disruptions. Indeed, a poll by Bank of America shows that a large majority of global investors expect a “soft” landing or better in 2024 — the most optimistic reading for almost two years.
But if you are a pessimist, political issues cannot be ignored. Geopolitical conflict is already raising transport prices. Just look at the latest attacks by Houthis in the Red Sea. And while the immediate impact of that has been mitigated by the fact that shipping usually declines in January anyway, the World Bank recently warned that its index of global supply chain stress is rising, and could repeat patterns last seen during the pandemic if the Red Sea disruption continues.
Other conflicts also pose threats, as do domestic politics. Greg Jensen of Bridgewater, for example, thinks investors are “under-discount[ing]” the inflationary threats that could arise from any putative Donald Trump presidential victory, since Trump would probably appoint a compliant Federal Reserve governor, impose high trade tariffs and unleash expansionary fiscal policy.
Of course, central bankers themselves are not allowed to factor in such risks in their models, or at least not officially. But risks of this sort explain why the Davos mood music was at odds with the market pricing. And it points to two key lessons: first, economists of all stripes urgently need to study supply-side issues, not just demand cycles; and second, it is smart for CEOs and investors to hedge this year. The potential range of outcomes is extremely wide.
