Fed/ECB Watch: Wait a minute

Market pricing as of 22/08/2024 based on short-term forwards of respective OIS curves (US: EFFR, EA: €STR).

Source: LSEG, RBI/Raiffeisen Research

The FOMC minutes from the July meeting were more dovish than expected. Quite naturally, most of the information has already been communicated in the July monetary policy statement and at the press conference but still the minutes provide us with some further insights.

First, the FOMC has already been concerned about a deterioration in labour market conditions. It needs to be kept in mind that this was before the July jobs report surprised to the downside and triggered a volatile long weekend on financial markets. "A majority of participants remarked that the risks to the employment goal had increaed, and many participants noted that the risks to the inflation goal had decreased." And "some participants" were concerned that the gradual easing in labour market conditions could turn into a more serious deterioration. Our learning is that while the monetary policy statement reads "achieving its employment and inflation goal continue to move into better balance", the FOMC's July meeting actually was all about the labour market.

Second, a rate cut in July was discussed (Powell hinted at this) but was not a likely outcome. "Several [FOMC members] observed that the recent progress on inflation and increases in the unemployment rate had provided a plausible case for reducing the target range 25 bps at this meeting or that they could have supported such a decision". Surprisingly, the minutues very clearly announced a rate cut in September: "the vast majority observed that, if the data continued to come in about as expected, it would likely be appropriate to ease policy at the next meeting".

Third, it seems to be the case that there is a dovish bias emerging in the FOMC. "Many participants" assessed the risks of restraining policy "too late or too little" as the dominant concern while only "several participants" warned about inflation risks if monetary policy restraint is eased "too soon or too much". This might not shape the path the federal funds rate will take but it is important for how the market is pricing it. Put differently, pricing a dovish bias to a base case is a sensible approach.

What does it mean? Just one day before Powell will deliver his remarks at Jackson Hole the minutes show that chances are high for him delivering crystal clear signals about a September rate cut. Further, with the FOMC having been that concerned about where the labour market is heading in late July already the Fed might want to reduce monetary policy restraint quicker than previously thought. The pieces are moving together for rate cuts at every remaining meeting of the year instead of a slower rate cutting cycle of one rate cut per quarter. On the magnitute, we continue to see the 25 bps size as the most likely one given that we are expecting a controlled cooling of the labour market and not a rapid deterioration. Still, we are putting our US interest rates forecast under revision and will release updated figures within a short time.

As outlined in our note on Jackson Hole meeting events in the US matter for the ECB. Without going through all the details once again, the bottom line is that an accelerated rate cutting cycle by the Fed increases the risks for the ECB to be perceived as falling behind the curve. Thus, euro area fundamentals are not the only thing that matter for the ECB. At a minimum, developments across the Atlantic need to be taken into account in the ECB's communication strategy, meaning that the ECB cannot push too aggressively against market pricing once the Fed is turning dovish. A diplomatic communication can find the middle ground between handling spillovers and elevated domestic inflationary pressure in the euro area.

So far, so good. Let's have a look at the details of the ECB's July monetary policy meeting. The meeting accounts are less surprising than - yet quite different to - the Fed minutes. In contrast to the Fed, the ECB is still very much concerned about inflation. And this is despite of the US economic momentum being much stronger than in the euro area. The ECB Governing Council even states that the short-term outlook has become more "stagflationary". On the one hand, leading indicators on the real economy have disappointed and question the pace of the euro area's economic recovery. Inflation readings have, on the other hand, not surprised to the downside.

The ECB "still needs to be watchful of upside risks to inflation" so the Governing Council states. First, services inflation shows no signs of softening and had been above earlier expectations for some time. Second, key building blocks of the "disinflation narrative"- pick-up in productivity and moderation in wage growth - had yet to appear in the data. This being said, the ECB still sees the inflation outlook from June as confirmed.

And "the September meeting was widely seen as a good time to re-evaluate the level of monetary policy restriction". We thus see our base case of a rate cut in September as confirmed. Further, the ECB emphasized repeatedly that a cautious approach is warranted: "with inflation coming down only gradually, it was seen as natural that the Governing Council’s policy response should be cautious." The next rate cut after September should thus only occur in December. Given that interest rate markets are pricing 65 bps of rate cuts until year-end there is some potential for a hawkish surprise but with the dovish risks from across the Atlantic the current pricing does not seem too unjustified.