Fourth quarter earnings kick off on Friday, with the big banks.

Will the trend of falling inflation, and the coming change in the direction of monetary policy, manifest in a weak earnings season?

If so, it would not be a negative surprise for markets.  Wall Street has already dramatically lowered the expecations bar for us (as they do).  We started Q4 with expectations of 8% year-over-year earnings growth.  That has now been revised down to just 1.3% growth.

Keep in mind, this comes in an economy that was running at a 2.2% annualized pace (based on the Atlanta Fed’s GDP model).

The analyst community continues to undershoot on earnings and undershoot on economic growth.  So once again, we head into earnings season with a setup for positive surprises.

On a related note, we talked last month about the impact of rising insurance premiums on the CPI data (namely shelter, physician services and transportation).

The yearly change in the motor vehicle insurance component of CPI (for November) was up 19.2%.  From pre-covid levels, it was up 35%.

Guess which industry is expected to be the largest contributor of positive earnings growth in Q4?  Insurance.  

Insurance companies are expected to have grown earnings by 26% over the past year.  

November core PCE was reported this morning.  This is the Fed’s favored inflation gauge.

As we’ve discussed over the past week, not only has inflation continued to go the Fed’s way (lower, toward its goal of 2%) but it’s accelerating lower.

Remember, Jerome Powell told us last week that they expected this November number (core PCE) to be 3.1% — the lowest since March of 2021.

In my last note, we looked at the index data heading into this report.  If we extrapolate out a 3.1% number, that means the inflation for November would have to go (slightly) negative (i.e. indicating deflation in November).

And as we discussed, we did already see deflationary price data in the eurozone and the UK last month.

So, what were the numbers?  This morning’s report on U.S. core PCE came in at 3.2% year-over-year, on a 0.1% rise in prices in November.

But guess what?  Had the government not revised DOWN the last four consecutive months of core PCE index data, the November monthly prices would have indeed fallen (i.e. deflation).

Bottom line:  With the Fed holding rates above 5% as inflation is closer to 3%, they are putting more and more downward pressure on the economy AND inflation.

On the latter, the Fed has already told us that they will have to start cutting rates “well before two percent” (the Fed’s 2% inflation target).  Why?  As Powell has said, if they wait for two percent, “it would be too late.”  They would overshoot to the downside.  And an overshoot to the downside means the Fed would risk inducing a deflationary spiral.

And as we’ve discussed often in my daily notes, a deflationary bust (low or contracting economic activity and falling prices) is far worse than inflation.  Deflation can be impossible to escape.

So, with the accelerating fall in inflation (which includes the government’s downward revisions on the past four months), the Fed will have to be aggressively cutting rates next year — and soon.  In fact, bets are now being placed for as early as January.

The next core PCE data will be reported on January 26.  The Fed meets on January 31.  The market is pricing in a 16% chance of a January cut, and now a near certainty of a March cut.  The Fed has projected June.

How “overly tight” is the Fed, at this point?  As the chart below shows, they are almost 170 basis points above where they want to be when inflation is at their target of 2% (the red line).

All of this said, despite the Fed’s throttling of the economy, the Atlanta Fed GDP model shows the economy is still running at a solid 2.3% annual rate.

Add in some rate cuts, a weaker dollar (which can absorb disinflationary pressures), and the deployment of fiscal packages (e.g. Chips Act) — and we could have a very good economy in 2024 with above average growth, stable 2% to 3% inflation, a tight labor market, and strong wage gains driven by the ongoing productivity boom.

The ingredients are there.

This will likely be my last Pro Perspectives note this year.  I want to extend my best wishes to you and your family for a Merry Christmas and a Happy and Healthy New Year!

PS:  If you know someone that might like to receive my daily notes, they can sign up by clicking below …

“How do you prevent a global economic shock that may (likely) come from reversing the mass liquidity deluge of the past two years (if not 14 years, post Global Financial Crisis)? 

You keep the liquidity pumping from a part of the world that has a long-term structural deflation problem, and that has the biggest government debt load in the world (exception, only Venezuela).

The Bank of Japan, in this position, can be buyers of foreign government debt (namely the U.S.) to keep our market rates in check (keeps the world relatively stable), which gives the Fed breathing room on the rate hiking path.  

And Japan’s benefit?  The world gives Japan the greenlight to devalue the yen, inflate away debt and increase export competitiveness (through a weaker currency).“

Indeed, the rest of the world spent the better part of the next year and a half executing an aggressive tightening cycle.  And in the face of the global tightening cycle, the Bank of Japan did indeed continue, pedal to the metal, with ultra-easy, emergency level, monetary policy.

Did the BOJ buy a lot of sovereign debt of the Western world, to help keep important global interest rates in check?  Yes.  Did the yen devalue?  Yes.  Did Japan finally muster some inflation, after nearly thirty years of deflationary pressures?  Yes. 

So, mission accomplished.  In coordination, the major global central banks were able to curtail record inflation, without having to raise interest rates above the rate of inflation — the historical inflation beating formula, but also a formula that would have crippled the economies of the Western world.  And the victory over inflation, was due in large part to the liquidity that continued to pump into the global economy from Japan.

With all of the above in mind, will the Bank of Japan end negative rates tonight and begin normalizing policy?  They shouldn’t.   

They held the line through the tightening cycle.  Now inflation in major economies is declining sharply, with the potential of inflation turning into deflation.  With that, the next move by major central banks will be easing.  And no central bank is more sensitive to the plight of deflation than the Bank of Japan.