Macro Signposts | 27 March 2024

Unless explicitly stated, views expressed do not constitute official PIMCO views.

Fed Reassesses the Balance of Risks – and Markets Respond

Risk management is at the heart of effective monetary policy. The communications following last week's Federal Reserve meeting indicate a shift in how Fed officials view the balance of risks, and in how they would respond to unexpected economic scenarios. These apparent shifts in the Fed's risk posture likely affect asset pricing, especially in markets most sensitive to interest rates and inflation.

How, specifically, did the Fed recalibrate its risk management approach? Here's what we gleaned from the meeting statement, new economic projections, and Chair Jerome Powell's press conference.

First, the Fed appears more willing to tolerate slightly above-target inflation, at least in the near term. At last week's meeting, Fed officials revised up their median core inflation projection for year-end 2024 to 2.6% from 2.4% projected last December, as measured by personal consumption expenditures or PCE. However, the median fed funds rate path projection remained unchanged at 75 basis points (bps) of cuts in 2024. Notably, this is 50 bps lower than the fed funds projection back in September 2023, when the Fed's inflation projection was the same as it is now. (For details, please read our blog post, "Fed Readies for Rate Cuts: Back Toward Neutral, or Mid-Cycle Adjustment?")

Second, during the press conference Chair Powell emphasized the Fed would ease policy if labor markets unexpectedly weakened. This contrasts with his statements throughout 2023 that some labor market weakening and rise in the unemployment rate should be expected as the Fed positions monetary policy to overcome elevated inflation.

How we read the Fed's latest signals
Here's what we believe the March meeting communications mean for Fed policy going forward.

First, there is a relatively high bar to stop Fed officials from beginning to ease policy this year. We still believe the first rate cut will most likely be in June. The inflation data seem supportive enough: Core PCE inflation printed at 2% on a quarterly annualized basis in both 3Q and 4Q last year. More recent data suggest core PCE in 1Q could land at 3.3%. If, when the Fed meets on June 11–12, 2Q core PCE is tracking in the neighborhood of 3% or below (using nice round numbers), then the year-over-year core PCE estimate for 2Q would settle around the middle of the "2-point-something" zone. We believe this would be low enough for the Fed to feel comfortable with launching an easing cycle in June. If the rate is higher, then the drivers of the reacceleration would play a key role in the Fed's decision to potentially delay the initial rate cut.

Second, the Fed appears attuned to macroeconomic risks stemming from the surprisingly resilient U.S. economy. Any obvious weakening in the labor markets would reinforce the Fed's resolve to cut. And unlike last year, when Fed officials used financial stability tools to arrest regional bank contagion, they are very likely ready to cut if systemic risks bubble up.

Third, there is an even higher bar for Fed officials to resume rate hikes. Fed officials in recent communications have been clear that they believe the policy rate has peaked. We suspect it would take a meaningful acceleration in inflation across a wide range of components, along with a continuation of above-trend growth and falling unemployment, to get them hiking again.

Market reaction, and where we see risks
Turning to implications for markets, we think the balance of risks for the pricing of the near-term policy path has shifted lower. Forward pricing (based on current overnight index swaps or OIS) is more or less in line with the Fed's projection, reflecting little if any perceived risk that the U.S. economy deteriorates and unemployment shoots up. We have some caution relative to these markets: While it's not our base case, we continue to argue that recession risks remain elevated. Labor market indicators have given off some puzzling and divergent signals recently, showing weakness under the surface despite generally still resilient real GDP growth.

Meanwhile, the distribution of risks around the inflation outlook has shifted higher, in our view, mirroring the upward revision in the Fed's median inflation projection for this year. The Fed's clear bias to ease despite inflationary trends – sticky shelter inflation, still elevated wage inflation, and goods deflation fading – implies that the Fed is willing to tolerate some above-target inflation. (Learn more in this blog post by Rich Clarida, "One Hike, Three Hints, and a Surprise Rate Cut.") To us, the Fed appears OK with any annualized core PCE reading under 3% ("two-point-something"). However, looking at short-term forwards in inflation markets, they aren't priced for a prolonged period of 2.5%–3% PCE (which equates roughly to 3%–3.5% CPI, or consumer price index).

The upshot: Both of these shifts should put downward pressure on real rates and ease financial conditions. That easing could leave the cutting cycle looking closer to a mid-cycle adjustment – where inflation reaccelerates and the Fed pauses for a time – than a steady march toward officials' estimates of neutral.

Read the previous edition of Macro Signposts on how U.S. economic resilience complicates the Fed's decisions and communications.

We welcome your questions about the global macro landscape. Don't hesitate to suggest themes or data for us to analyze and discuss: Please email [email protected].

For regular insights on U.S. policy via email, please write to [email protected] and ask to receive the Washington Watch.

All investments contain risk and may lose value.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

This material contains the current opinions of the author but not necessarily those of PIMCO] and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission | PIMCO Europe Ltd (Company No. 2604517, 11 Baker Street, London W1U 3AH, United Kingdom) is authorised and regulated by the Financial Conduct Authority (FCA) (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963, via Turati nn. 25/27 (angolo via Cavalieri n. 4), 20121 Milano, Italy), PIMCO Europe GmbH Irish Branch (Company No. 909462, 57B Harcourt Street Dublin D02 F721, Ireland), PIMCO Europe GmbH UK Branch (Company No. FC037712, 11 Baker Street, London W1U 3AH, UK), PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E, Paseo de la Castellana 43, Oficina 05-111, 28046 Madrid, Spain) and PIMCO Europe GmbH French Branch (Company No. 918745621 R.C.S. Paris, 50–52 Boulevard Haussmann, 75009 Paris, France) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the German Securities Institutions Act (WpIG). The Italian Branch, Irish Branch, UK Branch, Spanish Branch and French Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) (Giovanni Battista Martini, 3 - 00198 Rome) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland (New Wapping Street, North Wall Quay, Dublin 1 D01 F7X3) in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority (FCA) (12 Endeavour Square, London E20 1JN); (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) (Edison, 4, 28006 Madrid) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively and (5) French Branch: ACPR/Banque de France (4 Place de Budapest, CS 92459, 75436 Paris Cedex 09) in accordance with Art. 35 of Directive 2014/65/EU on markets in financial instruments and under the surveillance of ACPR and AMF. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2, Brandschenkestrasse 41 Zurich 8002, Switzerland). The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. PIMCO Asia Limited is registered as a cross-border discretionary investment manager with the Financial Supervisory Commission of Korea (Registration No. 08-02-307). The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Investment Management (Shanghai) Limited. Office address: Suite 7204, Shanghai Tower, 479 Lujiazui Ring Road, Pudong, Shanghai 200120, China (Unified social credit code: 91310115MA1K41MU72) is registered with Asset Management Association of China as Private Fund Manager (Registration No. P1071502, Type: Other). | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. To the extent it involves Pacific Investment Management Co LLC (PIMCO LLC) providing financial services to wholesale clients, PIMCO LLC is exempt from the requirement to hold an Australian financial services licence in respect of financial services provided to wholesale clients in Australia. PIMCO LLC is regulated by the Securities and Exchange Commission under US laws, which differ from Australian laws. | PIMCO Japan Ltd, Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association, The Investment Trusts Association, Japan and Type II Financial Instruments Firms Association. All investments contain risk. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is an independently operated and managed company. The reference number of business license of the company approved by the competent authority is (112) Jin Guan Tou Gu Xin Zi No. 015 . The registered address of the company is 40F., No.68, Sec. 5, Zhongxiao East Rd., Xinyi District, Taipei City 110, Taiwan (R.O.C.), and the telephone number is +886 2 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | Note to Readers in Colombia: This document is provided through the representative office of Pacific Investment Management Company LLC located at Carrera 7 No. 71-52 TB Piso 9, Bogota D.C. (Promoción y oferta de los negocios y servicios del mercado de valores por parte de Pacific Investment Management Company LLC, representada en Colombia.). Note to Readers in Brazil: PIMCO Latin America Administradora de Carteiras Ltda.Av. Brg. Faria Lima, 3477 Itaim Bibi, São Paulo - SP 04538-132 Brazil. Note to Readers in Argentina: This document may be provided through the representative office of PIMCO Global Advisors LLC AVENIDA CORRIENTES, 299, Buenos Aires, Argentina. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2024, PIMCO.

CMR2024-0327-3475306