Fed Faceoff

One-Dimensional Market: The weekend attack on Iran has had a muted market impact so far. However, as we wrote last week in “Strait Talk” investors are focused on the Straits of Hormuz because any action to impede shipping traffic in the Gulf could see oil double. As we mentioned, that would be a major stagflationary shock. There are many sides to this dynamic, including the potential to grant China a trade bargaining advantage since we are asking for Chinese intervention on our behalf to keep the Straits open. If China uses its edge to reduce tariff increases, then the global inflation picture improves. Many unknowns for now.

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Dot Against Dot: Waller vs. Powell

Soundbite: The clash in Iran got the headlines, but there was another important rift last week that got pushed under the radar. The dot plot showed a clear divide between those Federal Open Market Committee (FOMC) members forecasting no rate cuts compared to those expecting two cuts in 2025. Fed Governor Christopher Waller is leading the easing camp by calling for a July cut, while Powell is calling for patience. The latest FOMC statement revealed the Committee’s improved confidence, writing simply that  “uncertainty has diminished.”  On Tuesday and Wednesday, Powell testifies in front of Congress, where he will likely repeat his concern over tariff uncertainty. 

However, the ground may be shifting; this morning, Governor Michele Bowman said she could support a July cut as tariffs are likely to have a small impact on inflation. This is a significant break for her because she has traditionally been the most conservative FOMC voter. Since she moved, perhaps Powell will too.

Waller is saying that, since we know enough about how tariffs should turn out, it is prudent to cut preemptively before recent weakness in job creation becomes a real problem. In his words, “Why do you want to see a crash before you start cutting rates?” Meanwhile, Powell has not mentioned one concern over the labor market. The Chair continues to speak about the uncertainties of future tariffs. He told the press last week that “the amount of the tariff effects, the size of the tariff effects, their duration and the time it will take are all highly uncertain [variables].” That explains his hesitancy in cutting.

We believe the Fed’s fuse has shortened and will cut rates on weaker payroll data because a reduction of two million workers due to immigration is recessionary. We sense that a shift has occurred among FOMC voters, as the risk of stagflation is perceived to be lower due to the clearer picture emerging regarding tariffs. If true, then Waller is speaking for the majority of FOMC voters.

The Summary of Economic Projections showed a 0.3% increase in the median FOMC inflation forecast. That is the amount by which the Fed expects tariffs to raise prices. We have discussed their perspective before, saying the FOMC expects a 10% tariff increase, and since tariffs represent 10% of total consumer purchases, which translates to a 1% inflation bump. The consensus has formed around expecting manufacturers/exporters to assume one-third of the increase, and importers/retailers to absorb one-third, leaving the remaining .3% to pass through to higher consumer inflation.

Clear your schedule for 10:00 a.m. Tuesday, when Powell speaks to the House Financial Services Committee. Focus on any change in his comments about employment strength or the lack of tariff visibility. He also speaks to the Senate on Wednesday. Any alignment with Waller will push equities higher.

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Russian Economy: Exiled to Siberia?

Soundbite: In March, Russian Economic Minister Maxim Reshetnikov warned the Russian economy was facing hypothermia risks. Because he believed the country was on the verge of recession, he implored the Bank of Russia to cut interest rates for the first time in almost three years. The central bank must have listened, because they followed with a surprise cut from 21% to 20% on June 6. Unfortunately, monetary policy will stay restrictive to bring inflation down from 10% toward their 4% target. Additionally, the CEO of Russia’s largest bank said that with client profit margins of 15%, the central bank would need to drop rates another 600-800 basis points to 12-14% before corporations would increase capex.

 A 20% nominal rate with 10% inflation results in a highly restrictive 10% real interest rate. Real rates at this level are a major obstacle to investment.

The Economic Minister has turned cold on Russian growth due to those high interest rates choking investment. He also emphasized severe labor supply shortages that are depressing growth. The labor pool contracted by more than 2.5 million last year, not only due to the military, but also from young professionals fleeing to other countries.

Alexander Vedyakhin, CEO of Sberbank, agrees, adding that Russia faces a perfect storm of rates that are too high, a currency that has appreciated against the dollar by more than 30% since January, and the ever-present Western sanctions.

We have been negative on Russia due to the extreme headwinds of inflation, a lack of foreign investment, and an overwhelming emphasis on directing capital toward the war. Food inflation could be a major input for the Bank of Russia’s future actions. Potato prices have tripled in a year, which has hit low-income families hard. We are following the harvests this year due to their significance for monetary policy and the economy, which has geopolitical implications if Russia is seen as handicapped.

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Ground Zero

Soundbite: Negative interest rates? The Swiss National Bank cut interest rates to zero on Thursday, dropping their GDP and employment forecast. Swiss two-year yields flipped negative last month as traders expect a string of rate cuts after inflation went back below zero for the first time since 2021.

Switzerland’s central bank has steadily lowered interest rates since Q1 2024, dropping the policy rate 175 basis points over that time. The SNB cut rates twice this year: “We took heightened downside risks into account with our interest rate cut in March. These downside risks have since materialised.” Despite cutting rates 50 basis points this year, the Swiss Franc gained over 10% versus the Dollar. The central bank cut due to weakening inflation, the currency strength and the fact that unemployment is “likely to continue to rise greatly.” Their baseline forecast is for global growth to continue to weaken for the next few quarters, with tariffs likely to curb global trade causing a loss of buying power for US consumers as U.S. inflation rises.

The Swiss central bankers are in harmony with Powell as the SNB expects trade uncertainty to depress global investment momentum. Their Quarterly Bulletin is out on Wednesday, and we will look for additional insights.

As mentioned above, the FOMC statement thinks the risks around the U.S. economic outlook have diminished. If they are correct, we hope that the overhang on global investment momentum lifts, and the SNB does not need to cut further. If they cut, it recalls the prolonged 2015-2022 era of negative rates that could lead to another wave of inflationary quantitative easing.

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What to Look for This Week

(All times D.S.T.)

1. Friday June 27 at 8:30 a.m. Core Personal Consumption Expenditures Price Index for May. April came in at 2.5% and was the lowest level in almost four years. The Cleveland Fed estimate is for an unchanged level for May and June. Before Waller spoke, this had the potential to be a nonevent, but now, a large downside surprise could increase chances for a July rate cut.

2. Thursday June 26 at 8:30 a.m. Initial Claims for last week and Continuing Claims for the week ending June 14. Continuing claims have hit highs for the last two weeks not seen since November 2021 and have risen 50% since the levels from three years ago. The four-week moving average of aims has risen all year, and it is just shy of 250,000. Initial claims normally need to rise above 300,000 before it is seen in the red, but its ascent has our attention. Given Chair Powell’s satisfaction with labor market strength, these two key leading employment indicators have become even more relevant.

3. Tuesday June 24 at 8:30 a.m. The Current Account for Q1 is out. While the $300 billion deficit for Q4 2024 bettered expectations of $325 billion, a widening in the Q1 deficit to $380 billion is expected. We are focused on the goods deficit. It widened to $326 billion in Q4 from Q3’s $310 billion as exports fell.

FOMC Voters Speaking: The big event is Tuesday June 24 and 25 at 10:00 a.m. with Chair Powell’s semiannual Monetary Policy Report to Congress. On the heels of last week’s press conference and considering Waller’s comments, it could be a watershed event although that is not our base case. Governors Waller, Governor Kugler, Chicago Fed President Goolsbee and NY Fed President Williams speak today, Monday June 23. Fed President Williams speaks again on Tuesday June 24 at 12:30 p.m. Friday June 27 Governor Cook hosts a Fed Listens event at the Cleveland Fed.