Monday Morning Notes, 1/10/22
If You Don’t Have Time This Morning
There is nothing to stop the Fed from declaring the economy is at full employment at the January meeting and setting the stage for a March rate hike. The risks are growing that the Fed is falling sufficiently behind the curve that later this year or early next it will need to make a choice between risking a recession or letting inflation remain persistently above 2%.
Recent Data and Events
The headline job gains in the December employment report disappointed with a meager 199k net new jobs added to the economy though this likely understates the gain. Previous months were revised up by 141k and the household employment estimate rose by 651k which adjusted to match the establishment survey translates to a 301k gain. Better than reported but still below expectations for 440k jobs or higher.
There should be, however, little doubt at this point that the economy is starved for workers. We won’t get big jobs reports consistently without substantial gains in labor force participation. Those kinds of gains just aren’t happening yet:
Lacking a rapid recovery in labor force participation, the number of unemployed is now only 600k higher than prior to the pandemic and the unemployment rate has collapsed to 3.9%:
Responding to the super-tight labor market, wage growth accelerated:
Assuming underlying trend productivity is growing at 1.5%, a 7.6% wage gain translates into 6.1% inflation. Yes, higher wages could be supported by narrowing profit margins, but why would firms not protect margins when they can easily pass along price increases? The wage increases were broad-based:
The Fed, and many others, are holding out hope that inflation doesn’t spread to services. In contrast, my concern is that wage growth in the services sector will eventually translate into higher inflation. I don’t see why it shouldn’t happen – we know firms are having an easy time pushing through price increases because the nominal spending capacity is sufficient to absorb price increases. Indeed, aggregate weekly payrolls have pierced the pre-pandemic trend and show no signs of stopping:
The pace of growth is holding at an annualized rate of roughly 10%:
That’s nominal spending capacity growing at 10%. That combined with 2% inflation means 8% real growth. I don’t think that is happening, and what doesn’t show up in real growth will show up in prices. I continue to think inflationary pressures will remain elevated until the labor market cools down and nominal spending capacity eases. Looking at the longer series for production and nonsupervisory workers, here is what I don’t like about that story:
Historically, aggregate payrolls only roll over in a recession. That means we are expecting an endogenous return to pre-pandemic conditions in a series that largely hasn’t seen such endogenous reversals. Something to think about. I don’t know that we can go back to the pre-pandemic labor market, and I think the Fed has been slow to recognize how finely balanced the economy was at that time. Crank up labor demand and cut the labor supply via Covid, retirements, and less immigration and we have a whole new equilibrium to manage.
To be sure, the latest employment report predates the Omicron surge and the next report or two will see the impacts. Those impacts are likely large but also on the supply side in the form of weak employment numbers due to illness. The Fed is going to look through those impacts. The Fed can’t afford not to – the employment report screams late-cycle dynamics, yet it is still adding to the balance sheet and rate hikes are two months away. With each piece of data, the Fed looks more behind the curve.
Bloomberg has an article about staffing shortages in health care, particularly in rural areas. While this shouldn’t be a surprise (and I think speaks poorly for economic prospects in rural America), it is important to recognize the role of big box stores in labor markets:
Troy Bruntz runs Community Hospital, a 25-bed critical access facility in McCook, Nebraska. He’s been trying to recruit a third ultrasound technician for at least six months without getting a single application.
For lower-level positions, the hospital competes with the local Walmart store, where wages are rising. He monitors the pay offered by the retailer as well as the other large local employers, a hose manufacturer and an irrigation equipment supplier.
“What used to be an $8 job now is $15,” said Bruntz, a 52-year-old who once worked as an accountant for KPMG. “That’s the only way we get people to come to work.”
These kinds of pressures are not limited to rural areas, and eventually enough pressure on the bottom end of the wage spectrum will crash through resistance above. Speaking of which, state and local coffers are flush with cash and that will translate into wage growth. Axios is reporting that Georgia Governor Brian Kemp is proposing a $5,000 pay raise for state employees plus an increase in the 401k match from 3% to 9%. I expect this to become a trend.
Upcoming Data and Events
CPI is the data highlight of the week. Wall Street expectations are for another big number with core-CPI up 0.5% in December although note that the Cleveland Fed expects a modestly lower 0.4% gain. Needless to say, either number keeps the Fed on track but keep in mind that one number either above or below consensus doesn’t make a trend. The next big data release is the retail sales report. Wall Street is looking for a 0.2% gain in retail sales ex-autos but the Chicago Fed tracker anticipates a 1.3% decline:
The Chicago Fed number has been a good predictor of the direction of the miss relative to consensus. Of course, like with the CPI number, I am focused on the underlying trend. Other reports include industrial production and the preliminary Michigan consumer sentiment number for January. We might see some negative Omicron impacts in sentiment.
Very busy Fed week ahead. We should anticipate a lot of signaling that rate hikes are imminent along with words of caution about Omicron. The big events of the week are the Senate Banking Committee hearings for the nominations of Powell (Tuesday) and Brainard (Thursday). Other speakers include Mester, George, and Bullard on Tuesday, Barkin and Evans on Thursday, and Williams on Friday. The Beige Book also comes this week; watch for anecdotes about the ease of passing along price increases.
|Wednesday||CPI, MoM, Dec.||0.4%||0.8%|
|Wednesday||CP ex Food and Energy, MoM, Dec||0.5%||0.5%|
|Thursday||PPI, Final Demand, MoM, Dec.||0.5%||0.7%|
|Thursday||PPI ex Food and Energy, MoM, Dec.||0.5%||0.6%|
|Thursday||Initial Jobless Claims||203k||207k|
|Friday||Retail Sales ex Auto, MoM, Dec.||0.2%||0.3%|
|Friday||Retail Sales Control Group, MoM, Dec.||0.3%||-0.1%|
|Friday||Industrial Production, MoM, Dec.||0.3%||0.5%|
|Friday||UMich Consumer Sentiment, Jan. P||0.7%||1.6%|
Fed Speak and Discussion
The December employment report is more than enough for the Fed to declare victory on full employment and begin hiking rates. Yes, the headline number was disappointing but in the context with the rest of the report it reflects not demand side weakness but an ongoing labor supply constraint. Importantly, the Fed will see persistently high wage growth as a key indicator of full employment; Federal Reserve Chair Jerome Powell highlighted the employment cost index as one of the reasons for the Fed’s hawkish pivot last month.
It would be reasonable for the Fed to end asset purchases at the January meeting, but time is running out to communicate such a move. The Fed likes to move methodically and communicate its intentions well in advance. Moreover, unless the Fed wants to hike rates at the next meeting, they might not see much to be gained in return for the costs of what could only be described as a panicky move. That said, it would rationalize policy in some respects in that the increased chatter about the need to unwind the balance sheet is inconsistent with ongoing asset purchases. Ending asset purchases in January is the hawkish risk to the upcoming meeting but not the baseline. We have all week for the Fed to hint at that outcome, with a particularly interesting window between next week’s CPI release on 1/12, and the blackout period that begins 1/15. Assuming a bad CPI report, that’s an obvious space to watch for the Fed to signal that asset purchases will end abruptly at the next meeting, but I don’t expect that outcome.
In the near term, the Fed will be raising interest rates and initiating quantitative tightening. I continue to see chatter to the effect that the Fed is only talking hawkish so they don’t actually have to tighten policy. This is wrong. A March hike is basically a slam dunk and the only reason we can’t price it at 100% is the residual probability that something goes sideways over the next two months. Not only is a rate hike imminent, but quantitative tightening is soon to follow. Even former arch-dove San Francisco President Mary Daly agrees, via Bloomberg:
“I would prefer to adjust the policy rate gradually and move into balance-sheet reductions earlier than we did in the last cycle,” she said in a virtual panel discussion at the Allied Social Science Associations conference Friday. “I would not prefer to do it simultaneously,” she said, adding “you could imagine adjusting the balance sheet” after “one or two hikes.”
Most likely, the data is not going to influence this path in a dovish direction. The primary risk is that the Fed adds a fourth rate hike to the March SEP. That’s the direction the data is moving.
At this point, incoming data is likely to have more of an impact on policy from June onward than on the timing of liftoff. Last week we said that the story is moving toward what the Fed does in the back half of 2022. St. Louis Federal Reserve President James Bullard confirmed this take last week. Via Bloomberg:
“It makes sense to get going sooner rather than later, so I think March would be a definite possibility, based on data that we have today,” he said. “It would make sense to go ahead and lift off and then if inflation moderates as much as hoped by some forecasters then we would be able to slow down or not raise as fast as we otherwise would in the second half of the year.”
Again, liftoff and QT are happening, and right now the data says at least three hikes with a risk of four. I think the most likely outcome is that inflationary pressures do not moderate sufficiently over the next six months to prevent those hikes. That is how we should be thinking about the incoming data.
Fed hawks may have found a path by which to pull the doves toward an aggressive policy reduction. Consider this quote from Daly via MarketWatch:
“I would prefer a flatter funds rate and more adjustment on the balance sheet to get ourselves back to a place that’s more normal on the balance sheet,” she said.
If the Fed doves believe they can lower the rate path with more QT, their interests will align with the hawks’ and support our expectation that the pace of QT will be more aggressive than the last cycle. My guess though is that when it comes to a fourth rate hike this year or next, the Fed hawks will pull the rug out from under the doves and say that that balance sheet policy has uncertain economic impacts and policy rates are the primary mechanism by which the Fed communicates policy.
Finally, there is a substantial risk that the Fed is sufficiently behind the curve that it will need face the challenge of letting inflation remain persistently high or risk a recession. I see enormous hope that inflation moderates over the course of this year due to what amounts to base effects and falling used-car prices. That’s fine but consider three points. First, that bet was wrong all last year (and there is no end to the chip shortage holding car prices high). Second, there are no signs that the labor market is cooling down. And third, there is no question that the economy is littered with late-cycle indicators, including actual inflation, and yet the Fed has barely touched policy. It is almost the very definition of behind the curve. We should be at least gaming what happens in the back half of the year if inflation still holds near 4% at that time.
I think the Fed has been slow to recognize the risk that it is managing a whole new equilibrium. That realization is pushing it to maintain the currently policy path despite Omicron. Rate hikes are coming.
Good luck and stay safe this week!