Thirdly, the Fed mandate is to maintain price stability, the preferred barometer of which is PCE. However, if the Fed chose to look at inflation on a harmonised measure (HICP excluding housing and OER) such as the methodology used by the ECB, then core inflation in the US is currently 1.9% (a point recently made by Paul Krugman on X). The current level of divergence pricing between the US and European rate paths is not obviously consistent with the fact that on a harmonised basis US inflation is significantly below that of the eurozone. Indeed, even on the Fed’s preferred measure, the decline in inflation has been much smoother and more consistent (less bumpy) than the CPI.

And finally, it is important to consider the level of growth in relation to ‘potential growth’ in the context of policy restrictiveness. Productivity gains and significant supply side normalisation (a good example of which is the labour market normalisation we are seeing as a function of inward migration to the US) have likely pushed up the equilibrium growth rate, and thus recent growth data that has come in above expectations is less likely to be inflationary. Indeed, from our perspective, it is not sufficient to prevent further disinflation and thus ultimately policy normalisation - rate cuts. As we stated last week, ‘increased potential growth as a function of higher immigration and implied productivity gains are significant in relation to the Fed’s thinking - recent growth upgrades - but should also be important in relation to the market interpretation of the Fed’s reaction function’.

Thus, if inflation remains well behaved (and from a PCE perspective we would argue that inflation is already well behaved), then the bar for the Fed to normalise monetary policy is much lower than the current market pricing, from our perspective. This dovish asymmetric reaction function of the Fed is likely very important - especially given the recent sentiment swing - in relation to the June Fed meeting.

Finally, we would like to return to the last point we made last week - that the current consensus assumption is that the US economy will see higher growth, higher inflation and higher rates in the remainder of the year… this is a difficult triangle to square (so to speak). Especially if we consider that the recent ‘upside surprises’ to inflation have been supply driven (Oil/Gas prices, Insurance, Medical services) and thus likely constitute a tightening of consumer finances. This is particularly important in the context of recent conclusions by the Fed, that domestic savings in the US are almost exhausted. Something that is not consistent with higher demand growth.

For the first time this year it feels like markets are starting to question the strong growth narrative on the back of the increased likelihood of more protracted geopolitical tensions, weaker earnings in some instances and also on the back of the increasing difficulty of joining the inflation, rates, growth triangle against a higher baseline volatility on the back of higher uncertainties.

There is a famous Dornbusch quote that springs to mind given this nascent focus of the potential growth turndown and the market pricing of the Feds reaction function. “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could”. From our perspective this may well prove true of US interest rate cuts as the tightening of financial conditions and consumer finances continue to weigh on growth… Little by little.